Understanding and calculating intrinsic value is a crucial — and likely the most crucial — part of the investment process.

The catch, however, is that understanding and, particularly, calculating intrinsic value is not at all a simple process. As a concept, intrinsic value is rather straightforward. In practice, it is very much in the eye of the beholder.

This is not a bad thing, of course. Disagreements, as the old adage goes, are what makes a market. The fact that there isn’t a simple intrinsic value formula is what creates those disagreements.

That fact also is what makes investing potentially profitable — and, at the very least, interesting. In terms of purely fundamental investing, the goal is to find disconnects between intrinsic value and market value. There are many strategies used in pursuit of that goal, all of them imperfect, yet all of them important.

## What Is The Intrinsic Value Of A Stock?

In the broadest sense, the intrinsic value of a stock is the value at which a stock *should* be priced. It’s what the stock is worth as a share of an operating business. To oversimplify, the intrinsic value of a stock could be seen as the *correct* value of that stock.

There is a more technical intrinsic value definition. By that definition, the intrinsic value of a stock equals the sum of all of the company’s future cash flows, discounted back to account for the time value of money.

## Intrinsic Value Formula

Given that technical intrinsic value definition, investors simply need to figure out what, exactly, the sum of all a company’s future cash flows will be.

Of course, that’s impossible. It’s difficult enough to forecast what a company’s cash flow will be next year, let alone five or ten years from now.

But there are systematic approaches to estimating intrinsic value. Among the most common is a discounted cash flow calculation, often abbreviated as a DCF.

A DCF model estimates those future cash flows, and discounts them back at a specified discount rate. Each year’s estimated cash flow, on a discounted basis, can be calculated as:

Free Cash Flow in Year N / (1 + Discount Rate)^{N}

If a discount rate is 10%, for instance, $1.1 billion in free cash flow *next* year has a present value of $1 billion, as that latter figure *this* year, invested at a 10% return, would result in $1.1 billion in cash flow next year.

DCF, like other financial models, has a large dose of the “garbage in, garbage out” problem. The model is only as good as the inputs. If an investor believes free cash flow will increase 8% a year, her valuation will be off significantly if free cash flow instead declines.

The discount rate itself is a significant source of debate as well. Some models use a company’s weighted cost of capital, which measures the firm’s overall financing cost. Others use a somewhat arbitrary rate, one sometimes set at an investor’s desired rate of return for the investment.

Still, a DCF model at the least provides a useful framework for investors to understand the valuation implied by their expectations for growth. But it’s not the only framework investors use.

The Dividend Discount Model has a similar logic behind it, though it focuses on dividends returned to investors rather than free cash flow. In an era where dividends are far less common than they used to be, however, the DDM can’t be applied to many publicly traded stocks.

There are less detailed, less precise methods as well. Backward-looking earnings or free cash flow, or slightly forward-looking estimates of those metrics, can be used to calculate a price-to-earnings or a price-to-free-cash-flow multiple.

Those multiples in turn provide a shortcut to understand how much growth the market is pricing in going forward. A stock that trades at over 100x earnings is one that the market expects to grow quickly; a stock valued at 10x free cash flow is one where the market is fearful that cash flow might actually decline.

But those single metrics require significant understanding of other factors, such as profit margins, balance sheet leverage, and the competitive environment. And those single metrics can be overly simplistic. A stock trading at 10x earnings isn’t necessarily ‘cheaper’ than one trading at 100x.

Relative valuation is another method. If ABC Corporation is growing faster than XYZ Inc., but XYZ has a lower P/E ratio or P/FCF multiple, that might suggest XYZ stock is undervalued relative to ABC.

One obvious problem here, however, is that relative undervaluation doesn’t necessarily make a good investment. XYZ could be attractive relative to ABC — but that could also mean that XYZ stock simply will decline *less* than ABC.

In some cases, investors can even look at a company’s assets. Book value is an accounting measure of a firm’s assets less its debt. But a key term there is “accounting value.”

A company whose stock trades at a discount to book value per share may do so because its assets aren’t really worth the value at which they’re carried. Conversely, a firm that drives profits with relatively few assets (software companies being a good example) may rightly trade at many multiples of its book value.

## Intrinsic Value Example

All of these methods have value, because none of these methods are foolproof. Intrinsic value is a largely theoretical concept. Two experienced, successful investors can look at the same stock; one may buy it, and the other sell it short.

Those investors likely would use several, or maybe even all, of the methods used to estimate intrinsic value. They could start by looking at P/E and P/FCF multiples, to give an initial if broad sense of what kind of growth the market is pricing in. They could follow with a DCF model, estimating forward growth rates after a deep dive into performance over the past few years, the competitive environment, and other factors. Peer companies would be similarly analyzed, with those investors comparing valuations and growth rates across the sector.

None of those methods would precisely establish intrinsic value — or even definitively establish that there was a long or short opportunity in the stock. But it’s certainly possible that multiple methods could point in the same direction.

Imagine that ABC stock trades at $60 with earnings this year expected to be $3 per share. A 20x P/E multiple is not terribly aggressive; it generally suggests the market is pricing in something in the range of 10% earnings growth going forward.

An investor could believe growth will be faster than that P/E multiple would suggest, and build a DCF model based on those growth rates to estimate intrinsic value at $85 instead of the market price of $60. She could look at a stock in the same industry, which is trading at 23x earnings despite likely lower growth.

Given that all of these methods point to the same conclusion — that ABC stock is undervalued — our investor can have some confidence in that conclusion.

But, of course, not perfect confidence. To some degree, all of these methods rely on our investor’s prediction of growth being correct. Again, the model is only as good as its inputs.

## Intrinsic Vs. Extrinsic Value

Intrinsic value does apply elsewhere in the investing world, but in a different manner. Stock options have both intrinsic value and extrinsic value.

In the options world, however, intrinsic value has a far more defined meaning. It refers to the value of a stock option were it to be exercised immediately. The remainder (market price less intrinsic value) is referred to as extrinsic value (or, by some, as the “time value” of the option).

## Are Fair Value and Intrinsic Value The Same?

Yes. Fair value and intrinsic value can be used interchangeably. Both terms refer to the somewhat nebulous estimate of what a stock should be worth. Market value, in contrast, is specifically defined as the price at which the stock trades at the moment.

## Residual Income Models

Valuation methods based on earnings and/or free cash flow, such as a DCF model, do have a blind spot: they don’t account for a company’s cost of equity capital. A company could generate earnings that are positive but still substandard in the context of the equity raised by the company to fund its business..

The problem is that there is an “opportunity cost” to owning those substandard earnings. Investors easily could invest in another firm that is performing better. The residual income model recognizes that opportunity cost by accounting for the cost of equity. In contrast, a discounted cash flow model accounts only for the cost of debt capital (defined as simply the interest on outstanding debt).

A residual income model takes the earnings generated above the cost of equity, and adds that sum to current book value. This combination makes intuitive sense.

From an accounting perspective, book value (also known as shareholders’ equity) is equal to the current value of all of the company’s assets, net of debt. That includes tangible assets, such as cash, inventory, or property and equipment, but also intangible assets such as goodwill.

The sum of future residual income, to oversimplify, is the *future value* created above that of an average firm. Adding the current value of assets to that future value to be created should create a useful estimate of the firm’s entire valuation.

There are a couple of stumbling blocks here. The first is that residual income, like other valuation methods, retains a healthy dose of the “garbage in, garbage out” problem. Investors still are estimating future profits, as they do in a DCF model. Book value itself is imperfect. One notable flaw is that goodwill created by an acquisition can be written down if the acquired business disappoints — but cannot be written *up* if it outperforms.

The second issue is that residual income calculations are complicated. Residual income in a period is simply defined as net income less a so-called equity charge, which equals the cost of equity multiplied by shareholders’ equity for that period.

But a residual income model requires calculating the sum of all residual income going forward, leading to a highly technical calculation:

Here, *B** _{0}* equals current book value. ROE

_{t}is the return on equity at a point in the future;

*r*is the cost of equity (equal to the required rate of return in the stock, though other approaches can be used).

*B*

*is the expected book value at a point in time.*

_{t}Even setting aside the fact that return on equity and future book values need to be estimated, simply running this calculation is not necessarily easy. Still, this complex math highlights a simple truth.

What a residual income model says, essentially, is that a stock cannot provide a satisfactory return on investment if the company cannot provide a satisfactory return on its equity.

That is an important understanding for investors. Even if the price is a low multiple of earnings, free cash flow, or book value, those facts alone don’t mean the stock is a buy. If ROE is low and stays low, over time investors wisely are going to migrate to better-performing companies. As a result, even if multiples to earnings, free cash flow, or book value are low, the stock is unlikely to rise.

Again, the calculations are complex. But there is a simpler version of residual income models that can be useful: Economic Value Added, or EVA. EVA is defined as:

Net Operating Profit After Taxes (NOPAT) – (Percent Cost of Capital X Total Capital)

The math here is simpler, and slightly different — but the logic is roughly the same. NOPAT includes the operating profit for all investors, including debt holders. It is defined as operating profit (which excludes interest expense and tax payments) multiplied by (1 – effective tax rate).

In other words, NOPAT is the net profit a business would generate if it had no debt (and thus no interest expense) at all. Total capital includes shareholders’ equity plus debt.

And so if a shareholder expects a specific rate of return (again, the cost of capital), the company has to generate the same return off its capital base. To oversimplify, shareholders won’t see better returns than the business does.

## Why Intrinsic Value Matters

In a sense, the entire art of active investing boils down to evaluating intrinsic value. Active investing is based on the idea that, with hard work and patience, investors can find stocks that are undervalued.

But what “undervalued” simply means is that the intrinsic value of a stock — what it actually is worth — is greater than the market value of the stock — the price at which it can be purchased.

The catch is that intrinsic value, again, is unknowable. Different investors can have very different approaches to calculating intrinsic value. None will be perfect, or even close to perfect.

Of course, the fact that perfection is unattainable is precisely what makes active investing fascinating, challenging, maddening, and rewarding. If it were easy to calculate intrinsic value, everyone would do it — and there’d be no chance of having any edge at all.