The Concept of Intrinsic value in security analysis
Here’s a quote on intrinsic value in security analysis:
“To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight..” — Security Analysis by Benjamin Graham, David Dodd, Warren Buffet.
It is always exciting to recognise the discrepancies between the intrinsic value and the market price of a security. However, the concept of intrinsic value is often confused and difficult to tackle for many investors. The commonly known definition of intrinsic value is the value that is justified by “facts”; such as assets, liabilities, earnings, dividends and other definite values. In contrast, however, it is considered problematic for one to think that the intrinsic value for a security is definite and determinable.
In previous history of security analysis, the meaning of intrinsic value was considered the same as “book value”; the intrinsic value of a security or asset was defined as it entered into a firm’s books. This view is definite and accurate, but the meaning provides absolutely no information on the practical matter since neither the average earnings nor the average market price can be analysed with numbers of the book value. Subsequently, a new idea was developed; the intrinsic value was then determined by the earning power of a firm. But it has its problems.
We often look to the past to make decisions for the future; the phrase “earning power” basically implies a confident prediction of future results. On the other hand, it is simply insufficient to predict the growth or decline of a security simply by knowing what the past earnings have averaged. There is an uncertainty that the trends determined by the historical data will hold for the future. In other words, we need to know whether the trend can be used as a dependent guide for the future first to predict the future. However, it comes with great challenges. Therefore, although “earning power” is expressed as a figure and is derived by the concept of “intrinsic value”. It is still difficult to use and acceptable for security analysis.
Let’s consider an example,
If we follow the earning power model, we could take the average eps of the last 10 years and multiply by 10 to determine the intrinsic value of the stock of $260 (with average $26). However, this number is simply an arithmetic operation that provides no useful information for analysis; it’s purely artificial.
But what is the role of intrinsic value then?
The simple answer is: as analysts, we should not search to determine the exact intrinsic value of a given security, but whether or not the value is adequate to justify a decision regarding the security; whether to purchase a stock, protect a bond, or the value is consider higher or low than the market price.
Based on :
Graham, B., & Dodd, D. L. (2009). Security analysis, Chapter 2: THE SELECTIVE FUNCTION OF SECURITY ANALYSIS. New York: McGraw-Hill.
