by Josh Lowry

Created on: May 01, 2008   Last Updated: May 13, 2008

Intrinsic Value

Value investors, including Warren Buffett, often calculate intrinsic value when deciding whether to purchase a business or equity. One of the key objectives of value investing is to exploit the difference between intrinsic value and market value. When intrinsic value is higher than market value by a specific margin of safety, an investment opportunity is presented. While valuations are constantly changing with corporate earnings and market psychology, intrinsic value can be estimated. The subject of intrinsic value is extensive and only an overview of the topic will be discussed.

Intrinsic value is the discounted value of cash that can be taken out of a business or equity during its remaining life. The first step in calculating intrinsic value is to determine owner earnings. Owner earnings are net income + depreciation + amortization - capital expenditures. Owner earnings are the amount of cash an investor can put into his or her pocket each year. Because non-cash expenses (depreciation and amortization) are added back to net income and capital expenditures are subtracted from it, owner earnings are considered to be more accurate than net income by itself.

The second step is to determine the annual growth rate of owner earnings over the past five- to ten-year period. The annual growth rate will differ depending on whether averaging or compounding is used. To determine annual growth, the majority of value investors use compounding, especially when owner earnings have been inconsistent and contain extreme highs and lows. Once the annual growth rate has been determined, it is used to project future owner earnings.

The third step is to discount the projected future cash flows over the holding period. The future cash flows are discounted to reflect their present value. Present value is the amount an investor will pay today for the future. To determine present value, a discount rate is used. The discount rate is equal to the investor's opportunity cost. The opportunity cost is the return the investor could achieve by purchasing another investment with comparable risk.

When steps one through three have been completed, an estimate of intrinsic value is established. The fourth step is the apply a margin of safety to the intrinsic value to determine an acquisition price. Margin of safety is the amount below the intrinsic value (expressed as a percentage) an investor will pay for a business or equity. The founder of value investing, Benjamin Graham, recommended

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