What is intrinsic value?
Intrinsic value is the “real” worth of a business or share, separate from today’s market price. In Warren Buffett’s definition, it is the discounted value of the cash that can be taken out of a business during its remaining life. In other words, future money converted into today’s money and added up.
Buffett himself stresses that it is an estimate, not a precise figure. When interest rates move or forecasts of future earnings change, the estimate has to change too. Two people looking at the same facts, even he and his long-time partner Charlie Munger, will almost inevitably arrive at slightly different figures.
Say you want to buy a CNG auto-rickshaw to rent out. Its real worth depends on how much rent, after costs, it will bring in each month for several years and what it will sell for at the end. If someone at the market shouts a higher price, or sells one cheap in a panic, the cash the vehicle will produce does not change. That gap between price and worth is the heart of intrinsic value. The example is imaginary.
Why it matters to an investor
- To have a yardstick for cheap or dear: without some estimate of value, calling a share “cheap” or “expensive” has no basis.
- For a margin of safety: to measure the gap between value and price, you first need the value.
- To resist rumours and herd buying: the bigger question is not why the price is rising, but what the business is producing.
- To understand why share prices move when interest rates change.
Three different “values”
- Market price: what the share is trading at on the stock exchange today. It changes daily, even minute by minute, and swings with people’s hopes and fears.
- Book value: assets minus liabilities on the balance sheet. It rests on past accounting and says nothing about future earnings.
- Intrinsic value: worth derived from an estimate of the cash the business will produce in future. It is not printed anywhere; you have to work it out.
How it is estimated
Broadly there are three approaches. Asset-based: what the company’s net assets are really worth. Earnings-based: what the lasting profit is, and what is reasonable to pay for it. Cash-flow-based: bringing future cash back to today’s value, known as discounted cash flow (DCF). The CFA Institute also describes intrinsic value as the present value of expected future cash flows.
In Bangladesh, the Public Issue Rules 2015 ask issue managers pricing an IPO to consider several methods: net asset value, a value based on the weighted average of after-tax profit over the previous five years, and the average market price of similar shares (as reported in 2020; rules can change). It shows that professionals, too, look at value from more than one angle, and that the answers can differ by method.
What makes value change
- Expected future earnings: a new factory, new competitors or raw-material prices all change the value.
- Interest rates: when FDRs or savings certificates pay more, people will pay less for uncertain future earnings, so value falls.
- Risk and durability: the less certain the earnings and the weaker the protection from competitors, the lower the value.
- What does not change it: a share price falling or rising yesterday does not, on its own, change what the business is worth.
Worked example
- Say an imaginary company, “Rupsha Foods Limited”, has net assets (book value) of Tk 40 per share. Asset-based estimate: about Tk 40.
- Its lasting profit is Tk 6 per share, and you want a 12% annual return for this level of risk. If profit stays flat: 6 ÷ 0.12 = Tk 50.
- A little more optimistic, say a lasting profit of Tk 7: 7 ÷ 0.12 ≈ Tk 58.
Result: your estimate puts the value roughly between Tk 40 and Tk 58, not at one exact number. Where the market price sits against this range is a separate question. The numbers are only an example.
Common mistakes
- Treating your estimate as one precise number. Value is a range.
- Taking book value, the IPO price or a past peak price to be the real worth.
- Changing your estimate of value every time the price moves.
- Accepting someone else’s “target price” without knowing the assumptions behind it.
The market price says what people are paying today; intrinsic value says what the business will give in future. Estimate the second yourself, as a range.