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 or builds electric cars or helps people do their taxes. That business hopefully makes money, and more money than it spends.
What is a Business Worth?
What's 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 an owner of the business, is the amount of real cash it produces, year after year, as long as it exists.
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 can sell that 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.
What's that million dollars a year worth to you? That makes the question more interesting.
What is Intrinsic Value?
Suppose your factory will last for ten years, at which time either 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 somewhere.
The intrinsic value of the business is how much money it can produce for its owners over a time period, plus the value of its assets. For your chocolate factory, that's the cash of $1,000,000 every year for ten years plus whatever you can sell off the assets for. (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).
How to Use Intrinsic Value
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.
Business is a lot more complicated than a simple example, but this is an estimate and a baseline. 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?
A good company has a solid intrinsic value and a coherent plan to make more money year after year. A company with a low intrinsic value—or a negative intrinsic value—may someday be a turnaround, but it's a risk.
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.
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