Intrinsic Value - Pt. 1: Why So Important?

One of the most elusive and least understood investment terms is Intrinsic Value. You can go to Investopedia, a great source of information, and see their definition here. From an owner's perspective, the Intrinsic Value of a company is the true measure of the worth of an enterprise. With that being said, let's consider several additional points:

• The market may or may not be valuing the company based on its intrinsic value (for example, undervaluing the company based on its intrinsic value creates a value investing opportunity)
• The book value may or may not be related to the Intrinsic Value (book value is the current value of assets less liabilities)
  
• Determining the Intrinsic Value usually requires consideration of qualitative (subjective) and quantitative (measurable) aspects of the company
  

Let's look at one of my favorite ways of explaining Intrinsic Value. This example comes from the Berkshire Hathaway Owners Manual (that's right, Warren Buffet actually put together a 5 page guide to owning shares--talk about expectation setting). You can find it here. In his explanation, Buffett illustrates the intrinsic value of a corporation by comparing it to the intrinsic value of a college education. He calculates the intrinsic value of a college education as follows (I'm paraphrasing here):

The difference in earning power over a lifetime of working, in current dollars, less the cost of the college education, in current dollars

In other words, to calculate the intrinsic value of a college education, you would consider the wage differential over a work career of, 40 years, and covert it to current dollars. Let's say this is $1 million. If a college education currently costs $100,000, the intrinsic value of the college education is $900,000.

For a company, you would similarly determine how much cash you could pull out of the company in the future (profits, earnings, dividends, etc.), and discount this to determine current dollars (in $/share). This amount would then be compared to the current share price. These two amounts can then be compared on an apples-to-apples basis to determine the attractiveness of a stock.

In my next post, I'm going to take a look at a couple of different companies and contrast their Intrinsic Value. This will help us see the importance of future earnings on calculating Intrinsic Value.