On our site, we have an Intrinsic Value Calculator. This is an estimate of a stock's fair value; the current value of all cash an investment will produce.
"Intrinsic value is the number that if you were all-knowing about the future and could predict all the cash that a business would give you between now and judgement day, discounted at the proper discount rate." -- Warren Buffett.
A hypothetical scenario: StableCo, MatureCo and GrowthCo.
To elucidate the concept of intrinsic value, let's consider three hypothetical entities: StableCo, MatureCo, and GrowthCo. Each of these companies earns $1.00 per share, but they differ in their growth trajectories. StableCo, is not growing at all and never will, MatureCo is growing at 3% per year and will continue to do so, and GrowthCo, which will grow at 6% per year for the next 3 years, and 3% per year afterwards.StableCo: The Dividend Distributor
StableCo is not growing, so it doesn't have to invest any money in its business. Therefore, it is able to pay all of its $1.00 earnings per share as dividends, every year.
Instead of investing in StableCo, you could invest in a low-risk united States Treasury Bond. Suppose this yields 4%. Stocks are expected outperform Treasury Bonds by an Equity Risk Premium; since stocks are riskier, investors require a higher return. In this theoretical example, we know StableCo will earn the same amount every year, but in real life, various factors can cause stocks to perform porly. If the equity risk premium is 6%, the expected return on stocks is 4% + 6% = 10%. We will use this as our required rate of return, or Discount Rate. This means that money 1 year from now is worth 10% less than money today. If you pay $10/share for StableCo, you will earn $1 per year, which is a 10% return. Since that is our discount rate, the StableCo is worth $10/share.
MatureCo: Balanced Growth
Now, let's look at MatureCo. Since it is growing, it has to invest money in the business. Suppose it's book value (net assets per share) is $5. Its Return on Equity (ROE) is then $1/$5 = 20%, meaning the company earns 20% on the net value of its assets. If it grows at 3%, it will likely need to increase its net assets by 3%. So, its book value next year will be $5*1.03 = $5.15. That is, of their $1 per share in earnings, 85 cents can be paid as a dividend, and 15 cents will go towards investments in assets such as property, plant and equipment. There is a formula for this: the distributable earnings is expected to be Earnings*(ROE-Growth)/ROE = $1/share * (20-3)/20 = 0.85. MatureCo is growing 3% per year, so to get a 10% return, we'd need to receive a dividend yield of approximately 10% - 3% = 7%. Therefore, we can divide the $.85 dividend by 7% to get $0.85/.07 = $12.14. If we pay this price for MatureCo, we'll get a 10% return. This is higher than the value for StableCo because MatureCo's return on equity is higher than our discount rate. That is, the company can earn a higher return investing in its business than we can earn by buying stocks. Therefore, the company is adding value by growing its business.
GrowthCo: Temporary Rapid Growth
Now let's look at GrowthCo. Their earnings for the next 3 years will be $1.06, and $1.06*1.06 = $1.12, and $1.06^3 = 1.19. Using our formula to calculate distributable earnings, they can pay a dividend of EPS * (20-6)/20 = $0.74, $0.79, and $0.83. We discount this at 10% per year to get the current value of the next three years of dividends: $0.74/1.1 + 0.79/1.1^2 + $0.83/1.1^3 = $1.95. Then, in 3 years, GrowthCo will be equivalent to MatureCo, and will be worth 12.14 times their earnings, which will then be $1.19 per share. We need to discount this by 10% per year, and we will do so by dividing this value by 1.1^3. So, the value of GrowthCo is: $1.95 + 12.14*1.19/1.1^3 = $12.80
A note about dividends: Often, companies will often repurchase shares instead of paying dividends. This means they are buying their own stock and getting rid of it. Since there are fewer shares outstanding, shareholders now own more of the company. StableCo, for example, trades at $10/share and earns $1/share. Suppose it spends the entire dollar on share repurchases. It can repurchase about $1/$10 = 10% of its shares outstanding, so its earnings per share will rise by approximately 10% to $1.10, causing the stock's value to rise to approximately $11. An investor could then sell enough of their stock to essentially pay themselves a $1/share dividend. Their ownership in the company will then decrease back to the original stake. Thus, for the purpose of stock valuation, share repurchases and dividends are often considered to be equivalent ways to allocate capital.
Conclusion
We explored a methodical approach to evaluating a company's worth based on its ability to generate cash flows in the future, adjusted for the time value of money. This transcends temporary market movements, allowing investors to ground investment decisions in their expectations of a company's financial performance and growth prospects.In practice, the calculation of intrinsic value is subject to many uncertainties. Intrinsic value calculations hinge on several key assumptions, such as future interest rates, economic growth rates, technological changes, regulatory changes, etc. These factors can all influence a company's performance and, consequently, its intrinsic value. Intrinsic value is an important concept, but it is important to be aware of the uncertainties in financial forecasting.