What intrinsic value means

In simple terms

The price of a share is whatever buyers and sellers agree on today. The value of a share is what the business behind it is worth. The two are related but not the same, and they can differ for long periods.

Prices move every second, driven by news, sentiment, fear and enthusiasm. Value changes more slowly, as the business's prospects change. Fundamental analysis is the attempt to estimate value and compare it with price.

What intrinsic value is

A business is worth the cash it can return to its owners over its life: dividends, buybacks and whatever is left when it closes, or, put another way, the free cash flow it generates after reinvestment. Cash received in the future is worth less than cash today, so that future cash is discounted back to today's value.

Intrinsic value is that present worth of all future cash flows to owners. It depends on three things:

1. How much cash the business will generate.
2. When it will generate it.
3. How certain it is, which decides the rate used to discount it.

None of these is known. All must be estimated.

The main approaches

Absolute valuation estimates value from the business's own expected cash flows.

• Discounted cash flow (DCF): forecast free cash flows, discount them to today and add them up. The DCF lesson builds one step by step.
• Dividend discount models: a DCF using dividends; useful for stable, high-payout companies.
• Asset-based approaches: the value of what the company owns minus what it owes, useful for holding companies, some financial firms and businesses being wound up.

Relative valuation values a company by comparison with similar companies, using multiples such as P/E or EV/EBITDA. It is quick and grounded in market prices, but assumes the comparison companies are fairly valued. The comparable-company valuation lesson covers it.

The two approaches answer different questions. Absolute valuation asks what the business is worth on its own merits; relative valuation asks how it is priced compared with others. Good analysis uses both and investigates when they disagree.

Why value is a range

Every input to a valuation is uncertain. A modest change in the assumed growth rate, margin or discount rate can move a DCF value by 30% or more, as the sensitivity analysis lesson shows. A valuation that gives a single, precise number hides that uncertainty.

Price and value over time

Markets are often roughly sensible, but they overreact to good and bad news, follow fashions, and sometimes ignore businesses altogether. That creates gaps between price and value. But there is no guarantee that a gap will close, or when. A share that is cheap can become cheaper; one that is expensive can become more so. Estimating value tells you what to look for; it does not tell you when the market will agree.

Why it matters

Without some estimate of value, you cannot tell whether a price is reasonable. You are left relying on price trends, tips or how others feel about a share. Estimating intrinsic value, even roughly, gives you an anchor: a way to judge whether you are paying a sensible price for what you are getting, and a reason to hold or act when the market moves.

Limitations

Intrinsic value depends entirely on forecasts that may be wrong. Different reasonable analysts will reach different values for the same company. Valuation methods also work less well for very young companies, loss-makers and businesses whose future depends on a single uncertain event. Treat every estimate as provisional and revisit it as facts change.

Common mistakes

• Treating price as value. A rising price does not mean rising value.
• Treating a valuation as precise. Think in ranges.
• Relying only on relative valuation when the whole sector may be mispriced.
• Expecting the market to agree quickly with your estimate.

Try it yourself

1. Choose a listed company you know reasonably well.
2. Write down, in a sentence each, what you expect for its revenue growth, its margins and how long its advantages will last.
3. Find its P/E and its peers' P/Es, and note what range of value peer multiples would suggest.
4. Keep these notes; you will use them to build a simple DCF in the later lessons of this module.