What is Intrinsic Value?

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When you buy a stock—unless you're purely speculating about what other people will do—you're buying part of a business. Perhaps that business shows ads on web pages (GOOG) or builds electric cars (TSLA) or helps people do their taxes (INTU). That business hopefully makes money, and more money than it spends.

What is a Business Worth?

In the simplest terms, a business is worth the value it can create over its lifespan. That value to you, as a shareholder and owner, is the amount of real cash it produces, year after year, through its lifetime.

Suppose you own a chocolate factory. You can make a million chocolate bars every year. Each bar costs you $1 to make (paying employees, buying raw materials, keeping the lights on, shelling out taxes, amortized and depreciated capital expenses) and sell (shipping to stores, marketing, setting up coupons and other promotions).

You sell your amazing chocolate for $2 per bar. This puts $1 in your hand for every bar sold. If you sell each chocolate bar as it comes off the assembly line, that's a million dollars in your pocket every year. Not bad.

When is a million dollars worth more than a million dollars? What's that million dollars a year that your business can generate worth to you? That makes the question more interesting.

Intrinsic Value Measures the Money a Business Can Generate

Suppose your factory will last for ten years, at which time it's obsolete or everyone's sick of chocolate or you've decided to sell everything become a coconut farmer on a deserted tropical island. (Of course you sell your coconut to another chocolate factory, but that's not the point.)

If you sell your factory, what can you get for it?

The intrinsic value of the business is how much money it can produce for its owners over a specific time period, plus the value of its assets. For your chocolate factory, that's $1,000,000 every year for ten years plus whatever you can sell off the assets for. Your intrinsic value is, thus, at least $10 million dollars. Wow!

Valuing the assets is more difficult. Maybe you'll find someone to pay you to turn your factory into an awesome new battery technology factory. Maybe you'll find someone to turn it into an indoor skate park. Obviously the real world is more complicated than a magical chocolate bar factory. The factory and its machines are worth something. So is the land it's on. You can get an estimate of the liquidation value of those assets (see Net Asset Value).

Intrinsic Value is Inexact but Useful

Calculating intrinsic value isn't an exact science. You'll probably have to invest more in the factory to keep it running and to keep your workers happy. These things wear down over time. Furthermore, you might not be satisfied making only a million dollars every year. You could cut costs or raise prices or make more candy bars—and pay your workers more every year too.

Hopefully it's obvious now that intrinsic value calculates are baseline estimates. The simplest (yet still accurate and very, very important) way to measure the value of a business is to figure out how much money it can make over the next several years. What does it pay you to own it?

Can Intrinsic Value be Negative?

Suppose your factory costs you more and more to run it every year. Perhaps the price of cacao beans is going up by 20% per year, and you just can't raise the price of your $2 bar every year to make up for it. Maybe your factory is slowly sinking into the mud, and you have to keep buying more concrete to keep it from turning into a sticky underground supervillain lair. At some point, your business may be generating less revenue than it takes to keep it running.

Sure, you could still liquidate the land and the factory and all the assets you have (those poor almond trees in the back and the coconuts taking up space on the shelves), but it's entirely possible that a few bad years in business could rack up enough debts that you'll never be able to sell off everything and pay back the loans.

Intrinsic value calculations could keep potential investors from investing in your business then, and rightly so! This is especially important if you're on the investor side, considering whether to buy part of a business (or buy its stock)!

Use Intrinsic Value to Revise Your Investment Story

As with any financial ratio, the intrinsic value calculation tells part of a story. It can illuminate great opportunities, expose bad ones, and hide some details that you'll wish you had known. Be aware of its limitations, even as you use it to analyze potential stocks. When this number is out of line with everything else you're seeing, proceed with caution!

In general, a good company has a solid intrinsic value and a coherent plan to make more money year after year. In general, a company with a low intrinsic value—or a negative intrinsic value—may someday be a turnaround, but it's a risk. A startup which is spending lots of money to develop a product, find customers, or invent a market could have a negative intrinsic value for several years until its revenue accelerates. This isn't a bad situation. It's a common occurrence for a lot of startups. Yet it's also something you, as an investor, should take into account when you're deciding where to put your hard-won money.

Predicting the future isn't easy, but good companies are good companies, and great managers want the same thing that we as stockholders and investors want: to produce more value every year. Focus on the intrinsic value to help you decide the right price for a stock.

What to Consider Before You Buy a Stock | What is Present Value?