A hundred dollar bill is worth 100 USD. That’s the intrinsic value of the bill. The topic of intrinsic value is slightly more complex, but not by much, when it comes to a stock. The value of a stock is the sum of all the company’s future cash flows per share (essentially profits). The challenge lies in estimating what these might be, rather than hoping that some anonymous fool will pay for the stock without assessing its underlying value.

Intrinsic Value

Intrinsic value, or inherent value, is the value you gain ownership of when you purchase a stock. It is what your share of the company’s assets and cash flows is actually worth, regardless of what others are willing to pay for your stock.

You pay in currency (USD for example) for the stock, and you want at least the same value in USD as you paid. You wouldn’t want to buy a hundred dollar bill for 110 USD. In the stock market, many speculate that someone else will hopefully buy the stock for a higher amount in the future, without considering what underlying values the company can realistically create.

The problem is that if the company and the stock do not actually have intrinsic value, you will eventually run out of a queue of greater fools willing to pay more than the stock is worth. Let’s illustrate with some examples:

It’s Easy with Bonds

A bond pays 100 USD one year from now. Guaranteed by the state. How much are you willing to pay for it today? What is reasonable to pay?

Most agree that 100 USD is the absolute maximum to pay in any reasonable situation. If you pay more, you know you will lose money, and it is better to keep the money yourself. It’s as simple as the price you pay entirely determining your return. If you pay 90 USD, you get 100/90 – 1 = 11% return. If you pay 110 USD, you get 100/110 – 1 = -9% (negative) return.

When it comes to stocks, it’s a bit more complicated, but it’s essentially the same math. We don’t know how much money we will get “tomorrow” for our hundred dollar bill. However, there are scenarios that are more or less likely, and these scenarios are not affected by what you pay. Therefore, you can still treat the situation as if you know you will get amount X in the future, even if you don’t know what X is.

If you pay 100 USD today and get X USD tomorrow, you know the return will be much lower than if you pay, for example, 50 USD today and get the same X USD tomorrow.

X/50 – 1 >> X/100-1,

Where X is what the stock ownership turns out to be worth in a year.

Different Values for X

Try with Different Values of X:

For example, X=100 gives +100% if you pay 50, but +/- 0% if you pay 100. As long as the assessment of what X might be does not change significantly, there is rarely a reason to chase the stock and pay more just because others do.

Sometimes it’s harder than usual to forecast the future value X, and if you can’t do that at all, you shouldn’t invest. Often you can still reason your way to a range of forecasts and the likelihood of these occurring. Even if I don’t know if Apple will earn 150 USD, I might be reasonably sure it will be between 100-200 USD. If that’s the only year Apple exists and then shuts down without additional value, 100-200 USD is Apple’s intrinsic value.

You can illustrate the situation with three envelopes containing different amounts of money.

Suppose the envelopes contain 100 USD, 150 USD, and 200 USD, respectively. You can’t see how much money is inside. How much should you pay to take one of the envelopes?

If you know you can make the choice many times, the rational answer is “almost 150 USD,” i.e., the average content (but a bit less due to the risk that luck is never on your side).

Speculation in future prices vs investing in intrinsic value

Some highly risk-tolerant individuals are willing to pay 150-200 USD to make the choice just once. There’s a chance they might get the envelope with 200 USD on the first try. Some become so blinded by the potential that they have luck, that it will go very well, that the winning envelope will land in their hands, that they want to pay more than the expected average outcome.

In stock terms, this corresponds to paying slightly higher valuation multiples than normal, such as a P/E of 20 instead of a P/E of 15. This usually doesn’t work out well on average over time, but it can work – if you’re lucky.

You can, of course, hope that a company will grow quickly and make big profits and be willing to pay more than others for the chance the company will succeed. If you’re lucky or make a better assessment than others and pay less for the stock than the sum of future cash flows, you make a good deal.

But, it’s important to remember that no matter how good a company is or will become, there is a price so high that you will lose money if you pay it. Conversely, there is always a price, no matter how bad the asset is (e.g., a junk bond in a company going bankrupt), that is so low that you make a profit or at least break even.

Intrinsic Value is the Value of What You Get Ownership Of

And it doesn’t have to have anything to do with the market price of the asset (such as the stock). Even if no one ever wants to buy your stock, you will still have the right to your share of the company’s assets, profits, dividends, etc. THAT is the intrinsic value. That’s what you as a value investor focus on. And sometimes, a bit on a forecast of what others might be willing to pay to get a share of it in a more optimistic market later on.

Learn More Investing Concepts:

• Value Chain
• Specialization
• Cash Flow