Lesson 2 of 7
Intrinsic value against price
Intrinsic value is the cash a business will pay its owners, discounted. Price only says what someone will pay today.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Intrinsic value is the cash a business will hand its owners over its life, discounted back to today.
- Price is a quote, reset every day by whoever is trading. Value is an estimate, and nobody observes it directly.
- The two move for different reasons, so a share can be quoted almost anywhere while the business behind it barely changes.
Intrinsic value is what a business is worth, based on the cash it will pay its owners over time, discounted for the wait and the risk. Price is only ever a quote: what somebody is willing to pay today, and it can move for reasons that have nothing to do with the business at all.
One estimate, a year of quotes
- Quote, low point in the year$40
- Quote, high point in the year$65
Estimated value: $50
Value is a calculation
Williams's 1938 argument is that a business is worth the present value of the cash it will distribute to its owners, nothing more and nothing less. For a business that pays a steady amount every year forever, it reduces to one division.
Value equals Annual cash to owners divided by Discount rate.
Example$5 ÷ 10% = $50
Change the cash it pays, or the rate you discount it at, and the answer changes. Nothing about the share's quote enters the calculation. A real business rarely pays a flat amount forever, so an estimate of value is a forecast with a rate attached, not a single lookup. Klarman argues in chapter 8 of Margin of Safety that business value is a range, not a point, and that it moves over time.
Price is a quote, not a verdict
A price is set by whoever happens to be trading a share today, at whatever they are willing to pay. A price tells you what buyers and sellers expect the business to produce. It does not tell you whether they are right.
Price
- A quote, reset every day.
- Observable. Anyone can look it up.
- Can move on news that has nothing to do with the business.
Value
- An estimate, and a range rather than a point.
- Never observed directly. Two careful people can compute two different numbers.
- Moves when the expected cash or the discount rate changes.
A method that reads the price as evidence about the value has collapsed two different quantities into one.
Three questions any estimate answers
Buffett's 2000 letter applies the same arithmetic to farms, bonds, stocks and factories, then reduces every valuation to Aesop's bird in the hand: a bush is worth buying only if you can answer three questions about the birds said to be inside it.
Buffett's three questions
- How sure are you the cash is there?
- How much, and when does it arrive?
- What rate do you discount it at?
The third question has a real answer, the yield on a long-term government bond. The first two do not, which is why two reasonable people can value the same business differently and both be doing the work correctly. The letter's conclusion is that precise numbers here are a mistake: Buffett works with a range of possibilities instead.
Check yourself
A business pays its owners $5 a year forever. At a 10 percent discount rate, what is it worth?
- $5
- $50
- $500
Show the answer
Answer: B.
$5 divided by 10 percent is $50. This is the perpetuity form of Williams's 1938 argument: value is the cash divided by the rate.The same $5 a year, discounted at 8 percent instead of 10, is worth?
- $40
- $62.50
- $50
Show the answer
Answer: B.
$5 ÷ 8% = $62.50. The cash did not change; the rate did, and so did the value.Per Buffett's 2000 letter, what does an estimate of value need to answer, besides how much cash is coming?
- Yesterday's closing price
- How certain the cash is, when it arrives, and the rate to discount it at
- The average trading volume of the shares
Show the answer
Answer: B.
Buffett's three questions: how sure you are the cash exists, how much arrives and when, and the risk-free rate.Sources
- Williams, The Theory of Investment Value, 1938, on value as the present value of the cash a business distributes to its owners.
- Berkshire Hathaway shareholder letter, 2000, on Aesop's bird in the bush and the three questions every valuation answers.
- Klarman, Margin of Safety, 1991, chapter 8, on business value as a range that moves over time, not a single point.
What this leaves out
- The worked example uses round invented numbers and models no real business.
- A discount rate changes the answer a great deal. This lesson does not set one for you.
- Value is an estimate. Two careful people can compute two different numbers from the same filing.
- Nothing here is advice about any security.