Intrinsic value

Buy when the price is low. Sell when the price is high. This is the prescription given to those who are interested to invest in the stock market. But the underlying question is: when is it low or high? Fundamental analysts will prescribe comparing observed price versus intrinsic value. If the intrinsic value is higher than the price, buy the stock. If it is less, sell it. And if it is equal to price, hold it.

Intrinsic value is what the security of a company is worth given its present and future performance, business model, economic condition, financials, marketability of products and services, and management quality. Intrinsic value is also often referred to as fundamental value, the estimate of a company’s real worth. In its most basic sense, it is the present value equivalent to all future net cash flows expected from the business, discounted by the required rate of return. And the required rate of return is the ratio of income over the investment adjusted for the risk of the business. The required return represents what the investor demands as reward given the riskiness of the investment.

Warren Buffett puts it simply: “Intrinsic value is the discounted value of cash that can be taken out of a business during its remaining life.”

The concept of intrinsic value is powerful, even as calculating the same is at best an estimate. It is calculated using a quantitative model adjusted by appreciation of the qualitative aspects. The more popular tool involves computing the present value of expected future dividends or free cash flows from operations. Others will look at balance sheet items and calculate replacement value, market value, or even liquidation value of assets less liabilities. There is also valuation through comparables, most popular of which is price-toearnings analysis. Thus, its accuracy can never be exact, and it will rely on underlying assumptions.

Intrinsic value is likewise not constant. The determinants of value such as cash flows, growth trajectory, and risk change over