“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value”.
– Ben Graham, Security Analysis (1951 Edition)
Trying to determine the intrinsic value of a stock, car, home and iphone is an art form. There is no specific formula that can help you find the actual value of an item that does not have any error in it. There are many different formulas that can be used to determine the intrinsic value. But, unfortunately, there is no spreadsheet that you can plug numbers into that will give you that hard fast, rigid price.
Definition of Intrinsic Value
“A general definition of intrinsic value would be that value which is justified by the facts—e.g. assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. The intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor’”.
Ben Graham, Security Analysis
Or this from Joel Greenblatt,
“Value investing is figuring out what something is worth and paying a lot less for it.”
Finally this from Investopedia.
“The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option is in the money.”
All of these definitions say it pretty well. Intrinsic value is used for many things. It is mostly associated with buying stocks but it can be used for just about anything. Cars, homes, iphones, a loaf of bread. You get the idea.
Value investors use this theory and formulas to determine what the value of a company is. They use it to help find out what price they need to pay to achieve a margin of safety.
Notice that I haven’t mentioned price much? This is because intrinsic value focuses on what a company is worth, not how much it is trading for on the stock market. Price does not equal value.
“Price is what you pay, value is what you get.”
This is the first line in the value investing manual. Well, maybe not. But it should be. Price is a function of the vagaries of the stock market. Mr. Market has a field day with the price.
Value is something much more valuable than the price you pay for something. Can you put a price on your home? No, but you can put a value on it.
In the stock market world finding the intrinsic value is of utmost importance. This gives us the ability to determine a margin of safety. Which is critical to determining whether or not this is a company we want to invest in.
Why does intrinsic value matter?
In a broad sense using an intrinsic value formula to calculate that value gives you the opportunity to decide whether or not to buy or sell a company.