Intrinsic Value is the underlying value of a company or its securities, that can be estimated by means of fundamental analysis. The intrinsic value of a company should reflect the future earnings of the company, discounted to their present values.
The objective of estimating the intrinsic value of securities is to identify market inefficiencies. The premise is that market prices do not necessarily reflect intrinsic value. A security that trades at a discount to a conservatively estimated intrinsic value should, therefore, offer the investor a Margin of Safety.
Intrinsic Value Formulas
Calculating the intrinsic value of a company is not an exact science. Any estimation of intrinsic value requires the analyst to assess both qualitative and quantitative factors as well as making assumptions about future events.
The Intrinsic Value of a Security is a function of the following factors:
- Its net assets,
- its potential to generate free cash flow,
- its financial strength
- the quality of its management.
The aim is that any valuation of a specific security will become a quantitative analysis with a qualitative weighing.
1. Balance Sheet Assessment
- How are assets accounted for (fair value or mark to market)?
- What is the value of the inventory (lifetime, margins, etc,)?
- How do we value intangible assets (influence on cash flow, earnings, market value, etc)?
- Are fixed assets a fundamental attributor to earnings or can they be tradable?
- What are the capital requirements of the industry?
- What are the working capital requirements of the industry?
- Has there been share dilution in the past?
2. Free Cashflow Generation
- Where do earnings come from?
- How sustainable are margins?
- How does the company compete (cost, a market leader, niche or follower)?
- Which forces impact free cash flow (raw materials, vendors)?
- Is the operation likely to be able to increase sales?
- Is there much uncertainty about the future of the industry?
- Is the industry cyclical or secular?
3. Financial Strength
- How leveraged is the company?
- Is the company net cash positive?
- What is the interest percentage of its debt and short-term liabilities?
- What would happen to the company if credit markets would close for a year?
4. Management Quality
- How long has current management been in place?
- Does current management have a significant ownership in the company?
- What is the cost of its options compensation?
- What is the management record of allocating capital (reinvestment, m&a, dividends, debt reduction, share buybacks?
- Have there been any reports indicating mismanagement?
The process, the list and anything that has to do with the method is under constant scrutiny, so if you have any comments or thoughts, do not hesitate to share.
More on Fundamental Analysis
- What are Mental Models?
- A Brief History of Value Investing
- Predictive Attributes of Outperformance
- Martin Whitman | Four Sources of Wealth Creation
- Martin Whitman | Value Investing vs. Fundamental Finance