Intrinsic Value

One of the important concept of value investing is intrinsic value. We need to determine the actual value of an enterprise such that whether it is worth to invest in. In the Annual Report of Berkshire Hathaway 2005, Warren Buffet, the great follower of value investing, has clearly defined intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. To be more simple, it is the discounted cash flow method we have learned in our accounting course. The general use of discounted cash flow is to evaluate the feasibility of a business project. If you don't know what it is, you may just pick an accounting textbook in the book store and all the details will be presented very clearly. Howver, though the method is simple, it is very difficult to apply the basic estimations in making actual calculations. To be correct, one has to understand the future of the industry and company very clearly such that he can correctly estimate the percentage growth in cash flow of the company in its remaining life or a long period of time eg 10 to 30 years. Therefore, Warren Buffet usually invest in companies with business which is easily understood and forecasted. On the other hand, the percentage used to calculate the present value of cash flow generated is also very important. Warren Buffet usually use the interest rate of 30 year US bond as the risk free rate in calculation. After we have successfully calculated the intrinsic value of a company, we can compare it with market value of the company to see whether we have the safety margin when buying its stock.

Book Value vs. Intrinsic Value
Someone may argue that looking at the book value can be a good method in evaluating the value of a company. For example, many analysts usually use the Price to Book Ratio (PB ratio) to compare the value of banks. However, book value can only tell you the present value of the company and the intrinsic value derived from the discounted cash flow method is more forward looking which has taken into account the future performance of a company. Therefore, intrinsic value should be more safe and accurate in evaluating valuable investment opportunities.