Valuing investments is something that’s done in a number of different ways. In real time you can look at the market price of an asset and know what investors will pay for that asset right now. Often, it’s better to know what an investment will be worth in the future though, and for this value investors like to use something called “intrinsic value.” By calculating intrinsic value, you can get a deeper and more nuanced understanding of what an asset might be worth in the future. This can help to understand whether or not that asset is worth buying right now. Intrinsic value also follows one of the key principles used by Warren Buffet, which is to never invest in a business you don’t understand.
Intrinsic Value definition
Intrinsic value is a way to value an asset based on the cash flows it generates, which makes this most suitable for valuing the stocks of companies. The intrinsic value of the company tells you what the stock is worth based on the financial performance of the underlying firm. That makes intrinsic value different from market value, which is what people are willing to pay for an asset right now. The primary tool used to measure intrinsic value is discounted cash flow, or DCF. Using DCF lets us determine the value of an asset through analysis of the present value of forecast future cash flows. These are then discounted using a rate that reflects the risk associated with the asset. In order to calculate DCF it is necessary to estimate what the future cash flows of the company will be, and also choose an appropriate discount rate.
When using this analysis, you’ll find that larger expected cash flows and lower discount rates will lead to higher valuations. Often an analyst will use a range of different cash flows and discount rates to establish a range, which also reflects the uncertainties associated with forecasting the future performance of any company or asset. Intrinsic value and the DCF calculations were pioneered in the 1920s by Benjamin Graham and David Dodd. The most famous practitioner of intrinsic value investing is Warren Buffet, who has been using the method since the 1950s and has become arguably the most successful investor ever through his use of intrinsic value in selecting stocks.
How to Calculate Intrinsic Value
While DCF is often used by analysts to calculate intrinsic value, it is not the only way to do so. In fact, there is no universal standard for determining the intrinsic value of a company. Analysts can use a variety of valuation models that can include quantitative, qualitative, or perceptual factors. However, DCF remains one of the most popular methods for calculating intrinsic value of a variety of long-term investments and assets. In order to calculate intrinsic value using DCF you need three inputs:
- The estimated future cash flows of the company.
- The discount rate to determine the present value of the estimated future cash flows.
- A method for valuing the company at the end of our cash flow estimate, often referred to as terminal value.
Here’s the formula for calculating intrinsic value with these three inputs:
DCF = (1+r) 1CF1 + (1+r) 2CF2 + (1+r)3CF3 +⋯ (1+r) nCFn
DCF = Discounted cash flow
CF = Cash flow in years one, two, and so on.
TV = Terminal value.
r: = The discount rate.
Estimated Future Cash Flows
Analysts can use many methods for determining future cash flows of a company or asset. Typically, however they begin with the cash flows from the prior 12 months and then assume a certain growth rate for the asset into the future.
It is important to pay careful attention to the future growth rate because even small changes in this rate can have a significant impact on the valuation of the asset. Past growth rates can be useful and should be considered, but be careful about assuming a company with rapid growth now will continue to see the same above-average pace of growth for an extended time period.
Oftentimes a DCF model will estimate cash flows for a span of up to 20 years. Beyond that the model uses what’s known as a terminal value that’s calculated as a multiple of the cash flow in the final year. There are other ways to calculate the terminal value of an asset, but this way is simple and usually accurate enough. Other methods for estimating the multiple include using broader industry data, or by using the average multiple of the company that’s being evaluated. It’s also useful to calculate a range of multiples and then create an intrinsic value range.
The discount rate can also have a significant impact on the intrinsic value of an asset. The lower the discount rate, the higher the intrinsic value, and vice versa. Warren Buffet and many modern-day value investors use the risk-free rate, the yield on the 10-year US Treasury bill, or the yield on the 30-year US Treasury bond. Be cautious if doing this in the current yield environment in early 2021 however. With interest rates and yields so low you could get very low intrinsic values, but historic interest rates are much higher than current interest rates, which could mean your calculations are skewed towards lower intrinsic values. Aside from the rate used, many investors will also make adjustments to reflect the risk inherent in the business. This is considered to be quite subjective, and is the reason that many analysts will use a range of discount rates in the same way they use a range of growth rates.
The Limitations of Intrinsic Value
One of the limitations of intrinsic value is that not every asset has cash flows. That means you can’t always calculate an intrinsic value for an asset using DCF. One good example of this is commodities such as the precious metals gold and silver. Because they do not generate income there is no intrinsic value for the precious metals, at least not when using DCF. Another class of assets that has no intrinsic value using DCF is cryptocurrencies.
And while all companies may have cash flow, some are simply too difficult to calculate an intrinsic value that can be deemed as reasonable accurate. This includes highly volatile companies with erratic earnings, start-ups with no sales or profits, or companies with an uncertain future. It’s not that these companies don’t have an intrinsic value, it’s just that the intrinsic value calculated can’t be trusted to be accurate with any degree of confidence. Any calculation of intrinsic value is an attempt to determine the value of an asset based on its future cash flows rather than its current market value. This means intrinsic value of a company might be significantly different from its current stock price. While there are many other ways to value investments, intrinsic value is considered to be a cornerstone of fundamental analysis for value investors.