Monday, January 28, 2008

Intrinsic Value

What is a stock really worth? One answer is “whatever the stock is trading for in the stock market.” Unfortunately, this is not a useful answer. The stock market just tells you the price at which people are willing to buy and sell a stock.

The true value of a stock (also called the intrinsic value) is determined by the value of the business represented by the stock. If a business is worth $10 million, and there are a million shares, then each share is worth $10. But, how do we determine the value of a business?

Suppose that we know what is going to happen to ABC Company. ABC will pay a $1 dividend per share each year for the next 50 years and then close down. Now each person can decide how much to pay for a share that will pay $50 over 50 years. Some might be willing to pay $10 and others $15. This amount that you are willing to pay is your assessment of the intrinsic value of the business.

Suppose that you decide that the intrinsic value is $15. If you find that the majority of people think the intrinsic value is $10, should you change your mind? You might think it through again, but if your reasoning was sound and the stock is worth $15 to you, then you should start buying it for $10.

If you are knowledgeable and confident about your assessment of the intrinsic value of a stock, then you shouldn’t be swayed by the particular price of the stock on a given day. You should buy more stock when the price is below $15 and sell when it is above $15.

Of course, the real world is not as simple as this. We don’t know for certain what returns a business will produce. But knowledgeable stock investors still do their best to estimate the intrinsic value of a stock. They then buy stocks that look significantly undervalued and sell them when they become overvalued.

Sometimes stock prices go up or down for a good reason. When there is good or bad news about a stock, knowledgeable investors update their intrinsic value calculations based on this news. Then they look at the stock price to decide whether to buy, sell, or do nothing.

This all works very well for investors who can evaluate businesses and calculate intrinsic values well enough to beat the average market return. What about the majority of us who have no idea how to figure out the intrinsic value of a business? Has this whole discussion been irrelevant for the average person?

The short answer is no. I’ll show in the next post how this discussion is relevant and can help you to stay calm during turbulent conditions in the stocks markets.

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