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An investor considering buying a particular stock will probably have some idea in his head of what that stock is "really" worth -- what the financial world refers to as "intrinsic value." The intrinsic value of a stock is its actual value as a share of ownership in a corporation, separate from market hype, price momentum and speculation. Of course, different investors will have different opinions on a stock's intrinsic value, which is why stock markets exist to facilitate trades.
Credit for popularizing the concept of intrinsic value usually goes to Benjamin Graham, one of the original proponents of "value investing." In his book "The Intelligent Investor," first published in 1949 and regularly updated, Graham advised comparing the intrinsic value of a stock to its market price. If the intrinsic value is higher than the market price, the stock is underpriced and is a bargain. If the market price is higher than the intrinsic value, the stock is overpriced and should be avoided.
The Holy Grail
Of course, it is one thing to say you're going to compare intrinsic value to market price. It is something else to actually figure out what the intrinsic value of a stock actually is. Intrinsic value is frequently referred to as the "Holy Grail of stock investing" -- sought by many but forever elusive. One person widely acknowledged as having found the grail, or at least, glimpsed it, is Warren Buffett, who studied under Graham at Columbia University and used his value-investing strategies to amass one of the world's biggest fortunes.
Future Earnings Method
The general approach to determining a stock's intrinsic value is to estimate the company's future profits, calculate the present value of those profits and then divide the present value by the number of shares outstanding. The first two steps of that process are essentially subjective, which is why investors can come up with such widely different estimates of intrinsic value. Estimating future profits means making assumptions about the company, its industry, its competitors, even the direction of society itself. And calculating the present value of those profits means making assumptions about future inflation, interest rates and other economic factors that are often difficult to forecast months in advance, let alone years.
In "The Intelligent Investor," Graham offered a formula for investors to use to give their intrinsic value calculations a reality check. The formula -- in which "V" is the intrinsic value, "EPS" is the company's current earnings per share, and "g" is the company's estimated annual growth rate over the next seven to 10 years -- is as follows:
V = EPS x (8.5 + 2g)
The purpose of this formula is commonly misrepresented. Graham didn't intend for investors to simply plug in values for "EPS" and "g" and get the intrinsic value. Rather, he intended for investors to arrive at their own estimate of intrinsic value based on analysis of the company's performance, then plug in values for "V" and "EPS" to see what kind of growth rate would have to occur for their estimate to be correct. If the growth expectation is unrealistic, then the estimate of intrinsic value probably is, too.
- "The Intelligent Investor," Revised Edition; Benjamin Graham and Jason Zweig; 2003
- New York University: Intrinsic Valuation
- GuruFocus: Benjamin Graham's Misquoted Intrinsic Value Formula
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