Intrinsic value

The intrinsic value of a business is the discounted value of the cash that can be taken out of it during its remaining life.

What’s the value of a business? One possible answer is: whatever someone is willing to pay for it. But what someone is willing to pay fluctuates more than the intrinsic properties of the business because of the psychology of the buyers and the inefficiency of the market.

It is useful to instead think in terms of the intrinsic value of the business: the discounted value of the cash that can be taken out of it during its remaining life. Any assessment of intrinsic value is subjective because it depends on forecasting, but it is an objective way to think about business value.

What does it mean to discount the value of cash? Getting \$100 today is worth more than getting it in a year, because you can invest those \$100 today. If you invest them in a 1-year 5% bond you’ll have \$105 in a year. Equivalently, if you know you’ll get \$100 in a year’s time, that’s worth the same as about \$95.2 today if you can get a 5% return. That \$95.2 is the discounted value of the cash. With $CF_i$ as the $i$th cash flow and $r_i$ as the return you can get on money invested today and taken out on the cash flow date:

$$ DCF = \sum_{i = 1}^\infty{\frac{CF_i}{1 + r_i}} $$

Thus, to assess the intrinsic value of the business, you need to estimate the cash that can be taken out of a business in the future and the discount rate of that cash. Both of those are impossible to estimate with certainty or precision, but the better you can estimate them, the closer you get to the fair value of the business.

This model is useful if you build, buy, or sell companies or parts of companies. The market value will usually differ from its intrinsic value at any point in time, but in the long run it will approximate it:

As Ben Graham said: “In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.”

Warren Buffet, in Berkshire Hathaway’s 1993 Shareholder Letter

References

Warren E. Buffett, Berkshire Hathaway Inc. -- an owner's manual, http://www.berkshirehathaway.com/owners.html ()

Warren E. Buffett, Letter to the Shareholders of Berkshire Hathaway Inc., http://www.berkshirehathaway.com/letters/1993.html ()