Concept 1: Intrinsic Value.

As said in my last post, there are 5 concepts to be discussed in detail. The first concept I will discuss is the notion of intrinsic value.

‘Intrinsic value’ is one term that’s on every website that talks about stock market investing. Let’s try to crack down what it’s all about.

Intrinsic value is basically finding answer to one question – at what price do YOU think that a stock is available at a bargain and why?

It is basically an estimate. There is no correct intrinsic value. Two investors can be given the exact same information and both of them may come out with a different value on a company. The intrinsic value of a stock may be very different from its market price.

Why is it impossible to compute intrinsic value precisely?

Because, intrinsic value is the value an investor places after considering the business growth potential, market forces, products, management, earnings, ROE, shareholders’ value creation, competition, economic changes, political changes, etc. Hence, it is subjective.  There is definitely no way you could measure them all in terms of numbers and figures.

Famous investors have devised their own formulas for deriving the intrinsic value of a company. Benjamin Graham, the father of value investing and the person who popularised the concept of intrinsic value has given the following formula to calculate intrinsic value of a company.

  • Intrinsic Value = Current Earnings x (8.5 + 2 x Expected Annual Growth Rate)

You cannot apply this formula directly to any market conditions. That doesn’t make sense. This formula was created in the 1940s by Graham to find value stocks traded in US. So, an investor may have to find the intrinsic value based on his research and study.

INTRINSIC VALUE VS. BOOK VALUE

Some people confuse book value with intrinsic value. Both are different. Book value is basically an accounting measure. Book value is the difference between what a company owns and what it owes as recorded in the balance sheet.

However, a company may have valuable patents, brands, softwares, manpower, ideas, expertise, positive customer relations and licenses that cannot be measured in terms of money and such internally generated assets are not recorded in the balance sheet. These assets are strengths of the company which increases it’s value and are excluded while calculating book value.

The only case where such a figure is recorded is in the case of goodwill/patent rights when it’s acquired from another company by paying cash.

Hence, a software company may have more of such intangible (cannot be seen or touched) assets, and their book value as per the balance sheet may be meaningless since it does not show the actual worth of the company. An investor, who has considered the value of such intangibles, may be willing to pay more than their actual book value.  That value- The price at which he thinks that a stock is available at a bargain – is called intrinsic value.

That brings us back to what we said in the beginning. Intrinsic value is an estimate. There is no correct intrinsic value.

Many websites like Moneycontrol publish the book values of business. So there is no need to compute these figures. Intrinsic value, however is not published since it’s an estimated figure that varies from investor to investor.

CONCLUSION

  • Understanding intrinsic value is crucial if you are adopting value investing strategy.
  • Intrinsic value may differ from book value because of brand names, customer base, patents and other intangibles that are difficult for investors to quantify.
  • It may also be different from the market value – The current quoted price of the share which is driven by investor sentiments.
  • It is not possible to find accurately, intrinsic value of a stock.
  • There are various approaches but no standard formula for calculating the intrinsic value.
  • Investors should develop their own strategies and models for this purpose, according to availability of information and analysis tools he has. Many traders use different indicators like book value, P/E ratio, asset to liability ratio etc to find the intrinsic value of the stock.
  • Value investing is all about buying a stock below its intrinsic value.

In the next article,I’ll catch up with the concept of book value.

Till then , have a nice day !!

You may like these posts:

  1. Understanding price to book ratio
  2. 5 Investment concepts
  3. Balance sheet : what is it?

4 Responses to “Concept 1: Intrinsic Value.”

Mansoor

January 24, 2012 at 11:29 pm

This clears a lot of confusion between intrinsic and book value. Thank you, please do a post on one or several methods of how intrinsic value to be calculated. Thank you.

J Victor

January 25, 2012 at 10:13 am

The actual method to find intrinsic value is to discount the future cash flows to Today’s value. Discounting methods may be confusing for people from non finance streams. I’ll discuss it in my coming posts.

5 Investment concepts | Basics of Share Market

January 26, 2012 at 2:17 pm

[...] Concept 1: Intrinsic Value. [...]

rajan

October 19, 2012 at 3:53 am

dear victor,

for wipro bonus computation you have made an error…….calculations got mixed up when u miscomputed 1:2 bonus….

means for every 2 shares held you get 1….for ex if you have 100 then total becomes 150.

but in wipro case you have converted something else….in this ex according to you it comes to 100+200 i.e 300 total which is wrong…please justify.thx

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