The idea of intrinsic value is a vital concept in investing. Put simply, intrinsic value is the perceived or calculated value of an asset, an investment or a company. There are many formulas and calculations you can use to arrive at this figure, but the basic idea behind all of them is the same.
Intrinsic value has no relation to the company's share price. They are two completely different things, even though some analysts might tell you otherwise.
Long-term intrinsic value
Over the years, Warren Buffett (Trades, Portfolio) has written and talked extensively about intrinsic value and how to calculate a company's underlying fundamental value.
He's also discussed at length the difference between intrinsic value and market value (a company's share price).
In Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) 1996 annual report, Buffett devoted a section of his letter to talk about the "Relationship of Intrinsic Value to Market Price." Even though these few paragraphs are now more than two decades old, I think they're just as informative today as they were when the Oracle of Omaha initially sat down to write them in 1996.
Buffett started his discussion with a look back at his 1995 annual letter to investors:
"In last year's letter, with Berkshire shares selling at $36,000, I told you: (1) Berkshire's gain in market value in recent years had outstripped its gain in intrinsic value, even though the latter gain had been highly satisfactory; (2) that kind of overperformance could not continue indefinitely; (3) Charlie and I did not at that moment consider Berkshire to be undervalued."
As Buffett went on to explain, following an exceptional year for Berkshire and the stock market, the group's intrinsic value had caught up with the stock price:
"Since I set down those cautions, Berkshire's intrinsic value has increased very significantly - aided in a major way by a stunning performance at GEICO that I will tell you more about later - while the market price of our shares has changed little. This, of course, means that in 1996 Berkshire's stock underperformed the business. Consequently, today's price/value relationship is both much different from what it was a year ago and, as Charlie and I see it, more appropriate."
Following this information, Buffett went on to explain that over the long-term, the performance of Berkshire's stock "must of necessity match the business gains of the company."
However, in periods of market uncertainty or euphoria, the share price will trade at levels that may be disadvantagous or advantageous to long-term shareholders.
A low stock price in comparison to intrinsic value will offer shareholders buying in at that price a benefit compared to those selling. Buffett wished to avoid the following:
"Though our primary goal is to maximize the amount that our shareholders, in total, reap from their ownership of Berkshire, we wish also to minimize the benefits going to some shareholders at the expense of others."
On this, he offered some advice. The Oracle of Omaha tried to make it clear that the best approach for Berkshire shareholders, who want to maximize their wealth creation, is to hold shares in the company with a long-term outlook. Specifically, he wrote:
"Of course, the longer a shareholder holds his shares, the more bearing Berkshire's business results will have on his financial experience - and the less it will matter what premium or discount to intrinsic value prevails when he buys and sells his stock. That's one reason we hope to attract owners with long-term horizons."
This is applicable to all companies, not just Berkshire. Share prices fluctuate on a day-to-day basis, but the intrinsic value is usually more stable and easier to value. To be able to take advantage of a company's efforts to increase its intrinsic value, shareholders need to view the business with a long-term perspective.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- What Makes a Good Retail Business According to Buffett
- Warren Buffet: Everyone Wants an Easy Investing System
- Buffett's Views on How to Prepare for a Recession
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
Also check out:
