Perhaps the most asked question of a beginning value investor is this question: “How do we know the intrinsic value of a company?” and its such a hard question to answer because its so abstract and each investor has its own way of calculating for the intrinsic value.
But before I try to answer that question in my own words, let me first tell you that you won’t find any formula here. Getting that out of the way, lets first define what intrinsic value is. And this is the hard part. You define intrinsic value by how you calculate it. For example, Warren Buffett famously define intrinsic value as all the cashflow of the business from inception to its end, discounted back to the present. In other words, his intrinsic value is the amount of money he can earn, all from the life of the business and then what is that amount is in present time.
When you ask Ben Graham what is the intrinsic value, he will say something like this… Intrinsic value is the sum total of all the assets of the business less its debt.
Ask a speculator and he will say something like, the value of the business is how much other people will pay for it.
And there are a lot more of those as you go around ask other great investors. And the idea is that, each investor has its own way to define and therefore, calculate, the intrinsic value of a company. But what about me?
Honestly, I prefer Warren Buffett’s definition. It makes sense. But I don’t follow it wholeheartedly. First, I’m no Warren Buffett so I don’t try to be one. I know also that I’m not at par in the IQ department with the great investors. But that’s ok. Circle of competence is knowing the limit of it. So what do I do so I can get even a glimpse of that intrinsic value?
I try to estimate it. Or guesstimate if you want to be rude.
Which means, its just a guess. I try first not to put an exact figure of the intrinsic value, but an estimate of where it could be. The thinking goes like this, “if at this price for sure, its expensive and at this other price I know for sure that its cheap… then if I avoid the expensive price and wait for the cheap price, I know that the probabilities that the investment would be a good one in the future. I know I’m safe. There’s a margin of safety. And with that, I don’t have to know the exact number.”
We don’t need to use a weighing scale to know if a person is obese.
And that’s what we’re doing when value investing. At least, that’s how I think about intrinsic value. You just have to be sure if a company is cheap, that you don’t need to know the exact price of a stock. Surely you can find some metrics to help you with that. Just like you don’t need a weighing scale to know if a person is obese. Just look at his waistline or facial feature or his appetite and the food she eats and you know she’s obese. No exact weigh number required. That’s how I try to “guess” the intrinsic value.
But sometimes, that number appears to be obvious. But most of the time, you just work around it.