What is... | December 19, 2018

What is intrinsic value?

Guessing the intrinsic value of assets could make you a successful investor, but it’s easier said than done.


In its most general definition, the intrinsic value is the value of something “in and of itself” or in its own right.

That means the value is decided by looking at something on its own, without comparing it to anything else.

In finance, intrinsic value can be used to decide whether a certain asset is a good or bad investment. If it’s a good investment, the investor should be able to make a profit.

It’s no easy feat to determine the intrinsic value of an asset, though. There are two obvious aspects to the calculation: maths and knowledge.

But a third aspect is at play: behaviour.

The maths
The most common model for calculating intrinsic value is called Discounted Cash Flow (DCF). Here, investors look at how much money an asset could make over a certain period of time, divided by a discount rate.

This rate is a percentage that reflects the riskiness of an asset. There are many factors that influence the risk level, but it basically asks the question: how likely is it that the asset will actually make the money I expect?

Both the amount of money an asset could make and the risk level have to do with its cash flows. Cash flow simply means money coming in and money going out.

If the asset is a company, then money coming in is the money a company makes (this could be from selling products or services, from investments they hold and other sources).

Money going out is the expenses they have to pay, like rent for office spaces, salaries, taxes and other costs.

To calculate how much money an asset will make in, let’s say ten years’ time, you need to estimate how much money will be coming in and going out of the company (also known as its profit) each year and add those up for the next ten years.

If it’s fairly easy to estimate (for instance if a company’s finances have been very stable in the past), then the risk level is quite low. If there were lots of crazy spikes in income or outgoings, the risk will be high.

To calculate the intrinsic value of a company over 10 years, you take the profit from year 1 through to year 10, divide each of them by the discount rate you chose and add it all up. The amount at the end is the intrinsic value.

The knowledge
The actual maths isn’t too hard once you have the numbers. But getting those numbers is the tricky bit. You can’t know with certainty what the future cash flows are going to be like, nor how risky an investment will be.

Instead, investors have to estimate, predict and assume a whole range of factors, among which even things like management styles, the direction of the industry in general and more.

To know the real intrinsic value of a company or asset, investors would need to be all-knowing about that company or asset and its context, which is impossible.

To make things even more complicated, the intrinsic value is never one single value that everyone agrees to.

It will vary from investor to investor based on the factors they take into consideration during their calculations.

The behavioural aspect
Obviously, human beings cannot be all-knowing. So they can’t accurately calculate intrinsic value. There are several reasons for this based on what we know about human psychology.

For one thing, people tend to be overconfident about their own abilities. Calculating intrinsic value may at first glance seem quite simple. You can even find formulas to use and you just have to plug in the numbers.

But many investors might not realise how difficult it is to get the right numbers and they may fail to take several factors into account.

As a result, their calculation of the intrinsic value may be off the mark.

On top of that, people can’t stop themselves from making comparisons.

This is especially true if we have a lot of knowledge about a certain topic. It’s really hard to turn off or temporarily ignore information that’s in your brain.

So if you are trying to calculate the intrinsic value of company A, but you know a bunch about similar companies B and C as well, you are likely to make comparisons. This goes against the basic idea of intrinsic value.

The comparisons go even further than that. If a respectable investor claims that the intrinsic value of a share from Company A is worth £1, then others will often herd around that same number and make investments based on it.

If that number is wrong, however, they could all be paying the price.

The next question then becomes if intrinsic value actually even exists, a topic also debated in philosophy.

Its usefulness
That said, calculating intrinsic value does have its uses. It is typically used to check whether an asset is currently overvalued or undervalued.

If the market value of an asset (the actual price it’s being sold for) is higher than the intrinsic value, the asset is considered overvalued. If the market value is lower, it’s undervalued.

When making investment decisions, it’s best to choose assets that are sitting under their intrinsic value in the hopes they’ll grow in time.

You can even use intrinsic value in your own company. Image you want to launch a project that will cost you £100,000 you can use the same calculation to see if the outcome will generate enough revenue to justify the investment.

Investing

eZonomics team
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