Intrinsic Value

For investment purpose, intrinsic value is a very important concept because it represents the true value of a business.  Generally investors are concerned with the stock market value for which its stock price is affected by the market movement such as emotion versus the true earnings power that a company possesses.  As an investor, you should know the real worth of a business before making an investment decision because, on a long run, the stock market value eventually follow the true value of a business.

The definition of intrinsic value  is the discounted value of cash flows that can be taken out of a business during its remaining life. Future cash flows are affected by the strength and durability of the economic franchise, the quality of management and the financial strength of the business.  Cash flows in this case are defined as:

(a)  net income; plus
(b)  depreciation, depletion, amortization and certain other non-cash charges; less,
(c)  the amount of capitalized expenditures for plant and machinery, etc. that a business requires to fully maintain its long-term competitive position, its unit volume and make investment in all new value creating projects.

A company with an even amount of capital expenditures year after year, the net income approximates cash flows as a sum of capital expenditures equal to a sum of depreciation, depletion, amortization and certain other non-cash charges.

The discounted value of all the annual cash flows stretching to an infinite horizon is the annual cash flows earnings divided by the appropriate discount rate, when each year’s cash flows are identical to all the other year’s and the first is to be received a year from now:

Intrinsic Value = Annual cash flows / Discount rate

The discount rate is set as the required rate of return for an asset in this risk class. It is equal to the opportunity cost of placing funds in this stock rather than another one with equal risk. In other words, if the next best alternative use for the money shareholders put into ABC Co. pays a return of 10%, and that alternative has the same level of risk as ABC shares, then the discount rate for ABC shares is 10%.  If ABC Co. cash flows per year is $90 million, then:

ABC Co. Intrinsic Value = $90 million / 0.10 = $900 million.

By contrast, the current market capitalization of ABC Co. can be calculated as follows:

ABC Co. Market Cap = Share price X No. Shares = 0.91 X 1,274m = $1,159 million.
 

GROWTH OF CASH FLOWS

If we assume that ABC Co. has a series of new value creating projects it can invest in. By investing in these projects cash flows will rise by just 5% in each future year.  Then:

Most recent cash flows: US$90m
Next year’s cash flows ($90m X 1.05) = $95m
In two years, cash flows ($95 X 1.05) = $100m
In three years, cash flows ($100 X 1.05) = $105m, etc...

Each of these future cash flows is then discounted at the appropriate rate (10% in this case):

Intrinsic Value = ($95m / 1 + 0.1) + ($100m / (1 + 0.1)(1 + 0.1)) + ...

The formula below is equivalent to the one above--but much more simple:

Intrinsic Value = Cash flows / Discount rate - Growth rate

ABC Co. Intrinsic Value becomes = $90m / (.10 - .05) = US$1,800 million  
$1,800m / 1274m shares = $1.41 / share intrinsic value.

Note that even a relatively modest rate of growth in cash flows makes a large difference to the intrinsic value. A growth rate of 5% more than doubles intrinsic value (in the case where the discount rate is 10%) compared with the situation where there is no growth expected to occur.

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