Intrinsic value is what a business is actually worth, based on the cash it will generate over its remaining life discounted back to today. It is an estimate, not a fact, and it depends entirely on assumptions about growth, margins and duration. Two careful analysts will reach different numbers.
Price is what you pay
The share price tells you what the marginal buyer and seller agreed on this morning. It reflects everything the market currently believes, including things that are wrong, and it moves for reasons that have nothing to do with the business.
Intrinsic value is the separate question of what the business will actually produce for its owners. Over short periods the two are barely related. Over long ones they converge, which is the entire mechanism long-term investing relies on.
How it is estimated
Three approaches, and serious investors use more than one because each fails differently.
- Discounted cash flow. Project free cash flow, discount it to present value, add a terminal value. Theoretically the most correct method and practically the most fragile, because small changes to growth or discount rate move the answer enormously.
- Multiples. Compare against what similar businesses trade for, or against the company's own history. Fast and useful for context. It assumes the comparison set is fairly valued, which during a bubble it is not.
- Asset value. What the pieces would fetch sold separately. Usually irrelevant for a healthy operating business and decisive for one in decline, where cash-flow methods extrapolate earnings that are disappearing.
Why two careful analysts disagree
Because intrinsic value is not discovered, it is constructed from assumptions. Change the growth rate by two points, the discount rate by one, and the terminal multiple by a turn, and a reasonable range becomes a wide one. Neither analyst made an error. They simply hold different views about the future, which is what a market is.
This is why a single-point estimate carrying decimal places is a warning sign rather than rigour. The honest output is a range with the assumptions stated, and a clear view of which assumption the answer is most sensitive to.
The practical alternative
Because estimating intrinsic value requires forecasting, many investors invert the problem instead. A reverse DCF starts from the share price and solves for the growth rate the market already assumes. You are no longer producing a forecast; you are judging one, which is a far more tractable task and much harder to fool yourself with.
"This is worth $84" invites false confidence. "This price requires 20% growth for a decade, and this company has managed 11%" is a statement you can actually evaluate.
Margin of safety
Because the estimate is uncertain, Benjamin Graham's answer was to require a gap between price and estimated value large enough to absorb being wrong. Buy at a meaningful discount and an optimistic assumption becomes survivable rather than fatal.
The size of the discount should scale with how confident the estimate is. A stable business with predictable cash flows might justify a modest one. A company whose value rests on a growth rate a decade out needs a wide one, or a different method entirely.
Work out which valuation method fits before running one
A DCF on a hyper-growth company produces a confident answer built on nothing. Phase Check places any US-listed company on the lifecycle, and the phase determines whether cash-flow methods, revenue multiples or asset value is the tool that will actually inform you.
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Frequently asked questions
Related
- Reverse DCF, the inversion that avoids having to forecast
- Free cash flow, the input every valuation method runs on
- The 5 lifecycle phases, which valuation method works in each
- How to analyze a stock, why valuation is the last of seven steps