Return to Fundamentals: Intrinsic Value
Updated: May 7, 2020
In moments of volatility, it's always a good idea to revisit the things you know to be true. Instead of being swept along by emotional and irrational decision making, as investors, we want to be grounded in the fundamentals so that we can make clear-headed decisions with an eye towards our long-term goals as opposed to the ups and downs of the moment. With that in mind, we're going to be doing a series on some of the fundamentals from which we make investing decisions, beginning with the concept of intrinsic value.
Intrinsic value is the idea that there is a "true" value to something. Investopedia defines it as: "a measure of what an asset is worth. The measure is arrived at by means of an objective calculation or complex financial model, rather than using the currently trading market price of that asset." I like to use the example of shopping for basic household goods to help explain this idea of things having at "true" value. When I go to Target to buy certain household goods such as laundry detergent, I have a general idea of what those goods should cost. That price is the detergent's "intrinsic" value. As I peruse the detergent aisle, I determine whether or not a type of detergent is a good buy based on what the current price is relative to its intrinsic value. If the detergent is on sale for a lower price than I think it's worth, then I view it as a good buy, and I put it in my cart. If the price has gone up for some reason – maybe there's a shortage of laundry detergent – then it ceases to be a good buy, and I might consider looking elsewhere. The point is – there is a real value to what that item is worth and whether or not I think it is a good buy has to do with what the price is relative to that "true" value.
We see this concept play out when we turn to the financial markets as well. There is an intrinsic value to assets, and then there is that actual price of an asset at which it can be bought or sold. Whether or not an asset is a good buy or sell has to do with that relationship. A company can be doing great business and may be very popular amongst consumers, but if the price of the stock is too high relative to its intrinsic value – it's not a good buy.
How then are we supposed to know what a good measure of value is? In the previous example of household goods that I made, there are a few drawbacks. One is preferences – I may have a particular penchant for various brands of laundry detergent that influence how I value them. I may prefer a specific scent or an energy-efficient concentrate. That doesn't apply to asset prices. A particular stock will not perform one way for me but another way for you, which may sound straightforward, but there's a behavioral bias associated with our familiarity with a company and our belief that being familiar with it makes it a better buy. We'll discuss this bias much more in-depth later in this article series. Still, it's important to simply be mindful that our preferences as consumers should not intermix with our choices as investors.
As the Investopedia definition alluded to, the better option here is to utilize some form of calculation to conclude what we think an asset is truly worth. There are a variety of calculations that different managers use, but ideally, they all incorporate some element of cash flows. Fundamentally speaking, an investment's worth should be related to its earning ability. For many commonly used calculations, this involves discounting an asset's future cash flows backward to arrive at a "true" price.
How this works mathematically can get complicated quickly, but the takeaway is essential. When discounting cash flows, most models assume that the cash flows will continue in perpetuity. This assumption flows from the belief that unless a company is in distress (which would necessitate a different model) that it will continue to operate indefinitely until information about its operations tells us otherwise.
Short-term events like the coronavirus and related economic fallout – while painful at present – make up a fraction of all of the future cash flows of any given company.
Why is this important? Because it reminds us that short-term events like the coronavirus and related economic fallout – while painful at present – make up a fraction of all of the future cash flows of any given company. Think of it this way; your Starbucks might be closed or operating under a drive-through-only constraint. This likely means that Starbucks ' earnings will be squeezed for the next few quarters (or more – I make no claims here as to how long this situation will last). Nevertheless, if we believe that a time will come when Starbucks will return to operating at full capacity, then we start to see how the present squeeze is short-term and should have a short-term impact on the price of Starbuck stock. Furthermore, if we have a good idea of what the effect might be and can start to formulate an intrinsic value for a given asset, we can begin to look for discounts. In this way, we're able to find and exploit opportunity.