Intrinsic Value: What Is It and Why Does It Matter?

October 5, 2015

I recently picked up Howard Marks’ The Most Important Thing: Uncommon Sense for the Thoughtful Investor from the library for some light reading. For those of you who may not be familiar with the book, Howard Marks is the founder of Oaktree Capital Management, where he is famously known for sending his clients memos about “the most important thing” in investing. At one point he realized that each of those memos was written about a different “most important thing” than the last “most important thing,” leading Mr. Marks to publish a compilation of most important things. In one of those memos to clients, he notes that above all, the "most" most important thing, is the relationship between value and price: “For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.”

 

What Mr. Marks is talking about is a concept known as intrinsic value. Investopedia defines intrinsic value as: “The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.” One way to think of it is to imagine that there existed a way to know absolutely everything there is to know about a company and that you could take all of that information and determine the true price of that company. That true price would be the intrinsic value. Of course, there is no way to know everything there is to know about a company, particularly because we can’t predict the future, but what we can do is attempt to unearth intrinsic value, by learning everything we possibly can about a company.

 

Now that we’ve defined intrinsic value, this brings me to my second question – why does intrinsic value matter. As Marks put it in the previously quoted statement, intrinsic value matters because it helps us understand the difference between getting a good deal and a bad deal on a stock. One of the best examples I can recall of a price differing from intrinsic value is the IPO of Alibaba. When Alibaba first became available to retail investors, it was trading in the mid $90 range (it’s recently been trading in the $50 - $60 range). Everyone was really excited about the chance to purchase Alibaba stock because it sounded like such an incredible company, and it was. It still is. Unfortunately, the price that it was trading at didn’t necessarily reflect its intrinsic value, so while it was a good company, it wasn’t selling at a good price.

 

Comparing price to intrinsic value in the stock market is no different from shopping for common household goods at Target. I know that Tide is a great detergent. I love how it smells and it does a great job of getting stains out of my clothing. At the same time, I also have a pretty good idea of Tide’s intrinsic value – what it’s worth. If I went to Target this afternoon to buy Tide and suddenly the price tag said $100, I probably wouldn’t buy Tide. It doesn’t mean Tide is suddenly a bad product, it just isn’t worth that price.

 

In a recent article, I talked about seeking out value and investing based on the fundamentals. A key part of that strategy is seeking to understand what a good estimate of intrinsic value is so that we don’t overpay for something, but rather get a good deal. As investors, it’s always important that we are aware of our biases including the bias that just because a company is a good company it’s a good purchase. The price should always be tied to the value of a company and, as Marks reminds us, even a good company can become a bad investment when the price gets too high.

 

 

Marks, Howard. "The Most Important Thing: Uncommon Sense for the Thoughtful Investor." Columbia Business School Publishing.  2011.

"Intrinsic Value." Investopedia. 2011. http://www.investopedia.com/terms/i/intrinsicvalue.asp.

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