Monday, February 19, 2007

Thinking About Intrinsic Value

As a new investor I struggled with understanding what exactly “value” is when considering companies and their common stock. I read of “intrinsic value” but such a phrase is inherently contradictory to me. This is because strictly speaking, “intrinsic” is defined as genuine, real, and not merely apparent; whereas “value” is defined as some worth estimated by any amount agreed upon by two or more parties.

Consequently, the “intrinsic” part of the valuation process of a company appears to require an objective standard, while the “value” part may require a subjective application of an estimation of worth. Of course, finding the intrinsic part of value merely requires one to determine that portion of the stock price that represents book value (or one could narrow it further and find tangible book value, liquidation value, or even replacement cost). Unfortunately, most great business that have strong operating metrics do not often, if ever, sell for their “intrinsic” book value. Therefore, it has become necessary to find value by introducing as part of the "intrinsic value" equation an estimation of the value of the business as an ongoing concern looking towards the income stream which the business produces. And that is where the trap is found.
The subjective allure of “value” is a dangerous trap for a new investor who rushes the analysis to focus on growth and skips lightly over the objectively “intrinsic” part of the value analysis. Consider that 80% of the share price of Coca-Cola (KO) is not supported by any “intrinsic” value; rather nearly $40 of KO’s share price represents the expectation that KO and its brand will produce a continuing income stream as an ongoing business. While the prospects that KO will continue to operate as an ongoing business may seem certain, there are many other companies whose business prospects are not so grand. Yet many of these less stable companies’ share prices are set and valued by this expected future income stream as opposed to any true intrinsic value.

I realize then that when evaluating a business for a suitable investment it is appropriate for a new investor to seriously focus on the intrinsic portion of the valuation in order to ground ones expectations in tangible reality. While it is one thing to pay $47.00 per share for KO and receive only $7.00 in tangible value, it is quite another to do the same for a company with a less robust history.
Only after ascertaining the actual value of a company should an attempt be made, with restraint, to guess at the subjective estimation of that portion of value which lacks a basis in any intrinsic reality. Doing so may reduce the loss of capital.


Anonymous said...

So what your winning formula for finding intrinsic value?

ilanit said...

Banks are falling over themselves to lend money, at ultra-low interest rates and with no strings attached. And the private equity firms do not even need to have a good credit rating. They secure the debt they borrow on the assets of the companies they buy. With pre-determined debt interest costs, any increase in profits from reducing staff numbers, for example, goes straight to the Orange County business investors.