The Intrinsic Value- A Company's Real Worth

Introduction

Imagine walking into a store and seeing a shiny new gadget priced at $100. You pick it up, inspect it, and think, "Hmm, this feels like it’s worth $70 at best." That gut feeling? That’s your intrinsic value for the gadget.

It doesn't matter how you arrive at that estimate (of $70). It can be some complex calcualtions or your familiarity and past experience with similar gadgets or just a simple gut feeling. According to you, the intrinsic value of the gadget is $70.

Now, apply the same logic to stocks, and voilà- you have an intrinsic value for the stock!

The intrinsic value of a stock is the true worth of a company according to "you". It’s the price you’d be willing to pay if you were buying the entire business, not just a piece of paper that says you own a share.

The idea of intrinsic value is an important but abstract concept. As you delve into the article further, you'll discover that it's not just a numbers game. It's more about keeping in mind the idea of a company's true worth.

The intrinsic value estimate for any company will often differ from the market price of its shares. This discrepancy opens doors where a value investor can exploit opportunities and make important decisions.

Intrinsic vs Extrinsic Factors. What drives a stock's price?

It's pretty common to see stock prices bouncing around day to day. Sometimes those swings seems to be tied to some recent news about the company, but most of the other times, the price fluctuations seem random.

At any point of time, the market price of a company’s shares is a complex function that depends upon many variables. Not all of which necessarily pertains only to the company itself behind the shares.

Thus these factors or variables can be divided into 2 groups- intrinsic factors and extrinsic factors.

Intrinsic Factors

These are the things that speak about a company’s fundamentals— all the stuff directly connected to its health and future. Profits and debts of the company, the cash it generates, how it stacks up against competitors, its sectoral trends etc.

The intrinsic value of a company, needless to say, depends upon these intrinsic factors.

Extrinsic Factors

These are the outside factors which aren't directly tied to a company or its future but still influenes its share price heavily. They are like the stock market’s mood swings—sentiments, speculation, manipulation, sometimes absolute hysteria to buy or just outright panic to sell.

In the short term here is where the things get spicy. These external factors can make the stock price soaring or crashing faster than I can learn to pronounce "pneumonoultramicroscopicsilicovolcanoconiosis".

Due to these external sentiments, even a perfectly good company on occasions might see its stock price tank because of a broader market sell-off. Or, conversely, a mediocre company can see its stock price skyrocket simply because it’s the flavor of the month on the social media.

As long term investors, we should focus more on the intrinsic factors and try to tune out the outside noise. It's hard but doable.

A momentum trader on the contrary, tries to ride the wave of market sentiments and as such would pay more attention to the extrinsic factors. To him, the value of a stock lies in simply how much it can be sold to someone else.

Why Does Intrinsic Value Matter?

The current market price of a company’s share, as we already noted above, is actually the result of a combination of intrinsic and extrinsic factors surrounding its stock.

Meanwhile the intrinsic value of a company is the fair price you believe the business deserves — based only on its fundamentals, ignoring the noise from outside factors.

Imagine you study a company carefully and figure out that, based on your analysis, it should be worth somewhere between $90–$100 per share.

How you reached that number doesn’t really matter here — maybe it’s based on experience, simple math, or a deep financial analysis.

Now, you look at the market and see the stock trading at below that value, say $70 per share. Why? Maybe there's general market fear, or some negative headlines about the sector (extrinsic factors).

This presents an opportunity to you. You can basically buy $90–$100 worth of value for only $70. Sounds like a good deal, right? This simple idea is the heart of value investing — finding strong businesses selling for less than what they’re truly worth.

Calculating Intrinsic Value

While the concept is straightforward, actually calculating a precise intrinsic value can be tricky. There's no single, universally accepted formula.

Calculating intrinsic value is more art than science. There are countless methods, from simple back-of-the-envelope calculations to complex financial models that require a PhD to understand.

Discounted Cash Flows (DCF)

One popular method is Discounted Cash Flows (DCF). It’s like trying to predict how much money a company will make in the future and then figuring out what all those future money is worth today.

The formula looks something like this:

Fully understanding DCF involves grasping concepts like the time value of money and how to choose an appropriate discount rate, which are topics in themselves. But if you're interested, you can read about all of them in detail along with the method of Discounted Cash Flows here.

I personally don’t use DCF or any such complex methods, though I do respect the process and people who employ such techniques. These methods are no doubt valuable tools for professional analysts or those buying entire businesses or some major stake in a company.

But for most small investors like me and many others, understanding intrinsic value and its qualitative aspects is far more important than calculating it perfectly. Infact, there are many intangible qualitative factors like a management's expertise or a company's brand value; it is difficult to take into account these factors in any calculation anyways. These aspects can be just as crucial as financial metrics in evaluating a company's true worth.

Conclusion

Often times, neglected or out-of-trend stocks can be worth much more than their market price suggests. Many stocks in the event of a market (or just sector) crashe become undervalued and presents a good buying opportunity. And yet many of us investors miss out on these opportunities due to market noise.

Imagine if I give you a $10 bill and ask in exchange for just $9, you would likely agree to that in a heartbeat. Yet when the same scenario presents in the stock market, say $10 assets per share of a company you can buy for only $9, there is a good chance a lot of investors will skip that opportunity. Why? It is because of the fear, the panic that surrounds the market in tougher times.

This is where the concept of intrinsic or fair value comes into play. It is much more than just a number. For me, it is more like a "framework" to think critically about investments.

Just keeping in mind about the intrinsic value helps you to think like an owner, not just a stock ticker watcher. It encourages you to look past the daily market noise and focus on the underlying quality and potential of the business.

While calculating it precisely can be complex and subjective, grasping the difference between intrinsic value and market price can significantly improve one's investment approach. It's all about asking: "What is this company really worth, and am I getting it at a fair price?" If yes, then I can go for it despite what the market noise says.

Price is what you pay; value is what you get. — Warren Buffett

So, how do you approach intrinsic value in your investment decisions? Do you use a specific technique, or do you rely on your instincts? Share your thoughts and experiences, and let's continue the conversation in the comments.

Happy investing!