Too often, especially in today’s market environment, the price of a stock is confused with the value of a stock.

Phil Fisher famously said, “the stock market is filled with individuals who know the price of everything, but the value of nothing.”

But what exactly is the intrinsic value of a stock?

The intrinsic value is what a given asset or security is actually worth. The price of a stock is the cost you must pay to buy such an asset, whereas the intrinsic value is what that asset is actually worth. Just because you pay $10 for a share of stock, does not mean that stock is worth $10 — it could be more, it could be less. To determine the intrinsic value of an asset, there are several valuation methods you can do.

Determining the intrinsic value of an asset is important because it can help investors recognize whether the market price of an asset is undervalued or overvalued.

Investors such as Warren Buffett, Charlie Munger, and Phil Fisher, have popularized and brought to the forefront the importance of focusing on value when investing. The value of an asset, in relation to its purchase price, is crucial when investing because it is arguably the most important factor in determining the future returns of a company.

Preston Pysh and Stig Brodersen explain the importance of intrinsic value in this YouTube video:

Let’s look at an example. It’s a simplistic example, as there is more complexity in real-world scenarios, but it illustrates the point.

Assume Investor A buys company ABC at $100 per share, while believing the company’s stock is worth $500 per share. At the same time, Investor B buys company XYZ’s stock at $10 per share because there is a lot of hype around the stock. They’re not sure what they believe the value to be, as there’s no consideration given to the underlying stock’s value, but since it was only $10 per share, it must be “cheaper” than company ABC and the hype must mean there are positive future returns.

Over the next five years, both investors hold their positions and the market reprices itself, ultimately reverting to underlying intrinsic values, as it historically has. 

Investor A was right with their thesis — the company’s stock was actually worth $500 per share and trades at that price five years after they started their position. 

However, Investor B was wrong with their thesis. Company XYZ’s stock wasn’t actually “cheaper” than ABC’s stock like Investor B thought. Instead, when all of the hype wore off and the true business presented itself, XYZ was only worth $5 per share. Similar to company ABC’s stock, company XYZ’s stock was correctly priced over the five year holding period and traded at $5 per share.

Again, this is a simplistic example with round numbers, but it illustrates the importance of value, and being right about the value. Investor A calculated the value of stock ABC correctly and purchased at a price below the value. While Investor B gave no consideration to the underlying value and therefore ultimately purchased above it. This illustrates why individual investors care about the intrinsic value of assets.

When new investors begin investing in the stock market, they’re almost always focused on the price, not the value. The price of a stock, by itself, is irrelevant. It must be considered in relation to the underlying company’s value to have any context. 

When I’m speaking with new investors, I love to use these two companies as examples: Berkshire Hathaway (“Berkshire”) (Ticker: BRK.A) and Snap, Inc. (“Snap”) (Ticker: SNAP). I ask new investors, which company is cheaper?

Here is Berkshire Hathaway’s stock price and chart as of this writing:

Here is Snap’s stock price and chart as of this writing:

Every single new investor that I have asked that question has said Snap is “cheaper”. Their answer was driven by a price-bias. They can clearly see that one stock costs nearly $400,000 to buy, while the other is under $60. If they were asked which stock costs less, you could argue their answer is correct.

It does cost less to buy a share of Snap than it does Berkshire’s A shares. But I would argue that Snap isn’t necessarily cheaper. When we talk about “cheapness”, we’re talking about the price in relation to the value. The value is what matters, not the price.

Price is irrelevant without consideration of the underlying value because of the way ownership in a company is split. Let’s think of an entire company as a pie, with each piece of the pie equaling a share of stock. 

You can cut up your favorite apple pie into 5, 8, or 20 pieces, or really any number of pieces you want. But no matter how many pieces you cut that pie into, you’re left with the same amount of pie. It’s the same with a company. The company can be split into as many “pieces”, think stock, as it’d like, but the value of the company doesn’t change.

Take a company worth $100. If you split it into 50 shares, each stock is worth $2 per share. However, if you split it into 5 shares, each stock is worth $20. In the second scenario, the stock costs $20 to buy, whereas it only costs $2 in the first scenario, but the value of the company is the same — only the price has changed. 

Related: Podcast Episode – Intrinsic Value Assessment of Berkshire Hathaway

The most common way to calculate a company’s intrinsic value is to use a Discounted Cash Flow Model or “DCF Model”. 

If you read Berkshire Hathaway’s manual, Buffett says, “The intrinsic value can be defined simply. It is the discounted value of the cash that can be taken out of a business during its remaining life. As our definition suggests, intrinsic value is an estimate rather than a price figure. And it is definitely an estimate that must be changed as interest rates move or forecast or future cash flows are revised. Two people looking at the same set of facts almost inevitably come up with slightly different intrinsic value figures.”

What does he mean by “Cash that can be taken out of the business during its remaining life”? 

Buffett was referring to this, “If I could take out all the profit the company’s going to make over X number of years I’d own it, how much would that add up to?” 

He did it for 10 years into the future to compare that amount that he would collect to what he would make off of a zero-risk investment, which should be the 10-Year Treasury. The reason this is a zero-risk investment is because it is backed by the full faith and credit of the United States Government.

Future cash flows must be discounted to reflect what those cash flows are worth in today’s dollars. A dollar five years from now is not worth a dollar today, but what is it worth? The dollar five years from now must be discounted back, given a discount rate, to calculate what it’s worth today. The same happens with cash flows.

There are generally two ways to calculate the intrinsic value using the DCF model. Let’s look at both methods, starting with the discount rate method first.

Intrinsic Value Formula: Discount Rate Method

In the first method, follow the steps below:

1. You must forecast what you expect the company’s cash flows to be over the next 10 years;
2. Discount all future cash flows back to today’s present value using discount rate;
3. Then sum the present value to arrive at the intrinsic value.

We’ll assume the following cash flows for Company ABC:

In this example, I am going to use 8% as my discount rate. This includes the risk-free rate of a 10-Year Treasury, as well as an equity risk premium. This would result in a present value of just about $830. Remember, this is for the entire company, not per share. You must divide the total company’s value by the total number of shares outstanding.

If Company ABC has 100 shares outstanding, you must divide $830 by 100, which would mean each share is worth $8.30. If you could buy it for $4-$5, you may want to consider it. If you could only buy it for $16-$20, you may not want to invest in it. 

Intrinsic Value Formula: Probabilistic Approach

Let’s look at the same situation using the probabilistic approach, which is believed to be Buffett’s approach. In the second method, follow the steps below:

1. You must forecast what you expect the company’s cash flows to be over the next 10 years;
2. Rather than discounting the cash flows back to the present value using a discount rate, you can apply a weighted average approach, or a probabilistic approach to each cash flow;
3. Then sum those values to arrive at the intrinsic value.

We’ll use the same company and cash flow numbers as above, but add a probability percentage to each one, based on how likely we think each is to occur. 

Using the above probabilities would result in a valuation of about $848 for the entire company of ABC. Again, you would need to divide the total company’s value by the number of shares outstanding to arrive at the intrinsic value on a per-share basis.

Another variation to the probabilistic approach is to choose a Year 0 cash flow figure, or a starting point, then apply three different growth rates to the starting cash flow figure, with each growth rate having a different percent chance of occurring. In this case, you would say in the best-case scenario, I expect the company to grow at 10% per year and there’s a 30% that happens. In the most likely scenario, the company will likely grow at 5% per year and there’s a 50% chance that occurs. In the worst-case scenario, the company won’t grow at all, with a 0% growth rate, and a 20% chance of occurring. You would then calculate the weighted average of each scenario and arrive at the intrinsic value. This approach is very similar to the second scenario we looked at above, it is just a slightly different approach to applying probabilities to future cash flows. 

Related: Intrinsic Value of a Company: Free Assessments – Step-by-step guide to evaluating stocks

If you’re not comfortable with numbers or these concepts yet, don’t feel overwhelmed. If you can understand the theory and reasoning behind the calculations, you can use our online calculators to help you do the actual math. 

While we have discussed some ways to calculate intrinsic value, you may still find it overwhelming and challenging especially if you’re not too familiar with complex finance concepts and calculations.

To help you with that, we have our best selling value investing course, the Intrinsic Value Course. In this course, Preston and Stig teach you not just the step-by-step calculation of intrinsic value, but also how billionaires like Warren Buffet and Carl Icahn filter their results to pick stocks with the biggest returns.

Here’s the outline of lessons included in the course:

Lesson 1

• How to think about stock valuations
• How to value or not value dividend streams
• How to value an apartment complex

Lesson 2

• Discounted cash flow: The time travel of money
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Perpetuity

Lesson 3

• Determining the quality of earnings
• Understanding and locating moat
• Making projections into the future
• Valuation of a growth company: Tesla
• Valuation of a stable company: Berkshire Hathaway
• Options Strategy

Lesson 4

• Why billionaires use stock filters
• What is the TIP Value Multiple
• The enterprise value in detail
• Breaking down EBIT
• Putting the TIP Value Filter into practice

Plus you’ll also get access to our exclusive downloadable intrinsic value calculator. Check out the pricing and other inclusions here.

In our TIP Finance tool, we have a very simple-to-use calculator that allows you to calculate the intrinsic value of a stock, and see your potential returns if you purchased at today’s price. It uses the second probabilistic approach that we discussed above.

If you would like to see a stock valuation take place live using an intrinsic value calculator, you can see a valuation of AutoZone, Inc. here, or you can also watch the video:

You can also listen to some of our most popular episodes on We Study Billionaires, where we tackle the valuation of popular stock picks:

• The Intrinsic Value of Facebook with John Huber
• The Intrinsic Value of Lumen with Ben Claremon and Eugene Robin
• The Intrinsic Value Assessment of Disney with David Trainer

As you move forward as an investor, I challenge you to remember and consider what Phil Fisher said, “The stock market is filled with individuals who know the price of everything, but the value of nothing.”