Intrinsic Value

The basic premise of investing in stocks is to buy ownership in a company to share in its future profits. The intrinsic value of a company is a measure of this. It is defined as the total amount of cash that can be taken out of an investment over its lifetime discounted back to a present worth at an appropriate interest rate. In simpler terms you can think of it as the present value of a company’s future cash flows.

To determine intrinsic value the value of all future profits must be discounted. Despite there being a mathematical formula for its calculation, there is no one right answer because there are two unknowns in the equation. These unknowns are the discount rate and the amount of future profit. Discounting works like compounding but in reverse. If you deposit $100 in an account that pays 15% interest, then in 5 years that deposit will be worth $200 due to compounding interest. Imagine the corollary of this with a company that expects to have $200 in profits 5 years from now. Using a 15% discount rate, that profit is worth $100 today. Most analysts use a discount rate that matches a risk free rate of return like a long term US treasury bond. This is an appropriate rate because a stock with a rate of return that only matches that of a long term US treasury bond is really not worth anything. After all, why would someone accept the high risks of owning a stock when the same return could be owned risk free in a government bond? You may find debates over the most appropriate discount rate to use. It is important to realize that the differences in discount rates affect intrinsic value much less than the variations in a company’s expected future profits. The constantly fluctuating expectation for the company’s future profits is what really moves the price of a stock.

We are fans of intrinsic value at MarketBeaters because it is based on free cash flows and not earnings. We are not alone in our devotion to intrinsic value. It is the standard valuation method used by investment bankers to determine a company’s value for merger and acquisition purposes. Warren Buffet, arguably the greatest investor in history, basis his valuations on intrinsic value (he also favors a long term bottom-up analysis over top-down).