6.7 Concept of Intrinsic Value
WHAT IS INTRINSIC VALUE ?
The actual value of a security is different, as opposed to its market price or book value. The intrinsic value includes other variables such as brand name, trademarks and copyrights that are often difficult to calculate and sometimes not accurately reflected in the market price. One way to look at it is that the market capitalisation is the price (i.e. what investors are willing to pay for the company) and intrinsic value is the actual value (i.e. what the company is really worth). Different investors use different techniques to calculate intrinsic value.
One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock's 'real' value. After all, why would you be doing price analysis if the stock market were always correct? In financial jargon, this true value is known as the intrinsic value. For example, let's say that a certain company's stock was trading at Rs 176. After doing extensive homework about the company, you determine that it really is worth Rs 400. In other words, you determine the intrinsic value of the firm to be Rs 400. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value. This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals.
There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long 'the long run' really is. It could be days or years. This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up with the fundamentals.
But the big challenges here are two-fold:
- You don't know if your estimate of intrinsic value is correct.
- You don't know how long it will take for the intrinsic value to be reflected in the market.
Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in the hope of finding investments where the true value of the investment exceeds its current market value. For example, value investors who follow fundamental analysis look at both qualitative (business model, governance, target market factors etc) and quantitative (ratios, financial statement analysis etc) aspects of a business to see if the business is currently out of favour with the market and is really worth much more than its current valuation.
Intrinsic value, contrary to popular belief, is not necessarily the fair market value of an item, investment, asset or business, but the sum of the value inherent in its parts. A car might be sold for Rs. 3,00,000, but that includes the profit margin ensured by the dealer. The car’s intrinsic value might only be Rs. 2,50,000, even though it can be sold for a higher price. You can calculate intrinsic value in different ways depending on the item you are valuing.