What is Intrinsic Value?

What is Intrinsic Value?

If you follow the world famous investment guru, Warren Buffett’s investment philosophy, you will see that his main investment principle is to invest in a company at its intrinsic value, which will then allow you a desired margin of safety. This is what he meant by paying a fair price for any investment, just like his famous saying ‘invest in a great company at a fair price rather than a fair company at a great price’.

One of the most popular tools used in the world of value investing is the concept of intrinsic value. Intrinsic value is the underlying fair value of a stock based on its future earnings power. It was first introduced by Benjamin Graham. Sometime in 1930s, he wrote a book entitled Securities Analysis, which is still one of the main books on the subject today. Graham was also the mentor to the legendary investor Warren Buffett, who started investing following Graham’s investment principle, further adapting it based on his own interpretation and investment philosophy.

At the end of this article, you will be able to define and calculate intrinsic value as well as identify how it affects your investment decisions.

Definition of ‘intrinsic value’ and margin of safety

According to Graham, intrinsic value is the value of the company to a private owner. It is the price of a company that the owner will sell, which will reflect all the facts, including the value of its assets, earnings, dividends as well as potential future prospects. In stock investment, the concept behind the ‘intrinsic value’ is basically the value that can be taken out from a business. But, having the possibility of error in calculating intrinsic value, the careful investor should also provide for a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value. Based on Graham’s principle, if you can pay as little as two-thirds of the stock’s value, you’ve really got nothing to lose.

Now that we have an idea of what intrinsic value means, the trickier part is to determine how we are to arrive at this value for each business or stock. Since it relies on future earnings projection, an investor must decide upon their own methods and assumptions of arriving at the intrinsic value of a share and the margin of safety that they want for themselves.