Blog #23 : Understanding The Intrinsic Value
In this blog we'll learn about a stock investing strategy and how we should go about determining which stocks to invest in. To do that, let's take stocks out of the picture for a minute and level-set why we invest in companies? When we invest in companies we're taking cash out of our pocket in the hope that the business will grow, be profitable and give us back more cash than we have put in. We want our hard-earned money to work for us and grow itself. That's the basic mantra, but it's important to point out something very important here because plenty of people lose sight of this that it's the cash we care about. When we invest in a company, there's going to be a lot of noise out there like how much equipment or inventory it has how much debt it owes etc. But we shouldn't let this noise derail us. At the end of the day we as investors care about how much cash the business can give back to us. All these other metrics like equipment inventory and debt only matter in a context of helping us determine the amount of cash the company can generate for us.
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Cash we can put into our bank account. We can use it to buy food or car or pay for college. The company will own a bunch of assets like machines, furniture etc but unless the company can convert them into real cash, it's really not that useful to us as investors. With that it's evident to us that the value we're getting from our only ship of a public company is the value of all the cash that can be taken out from it and be returned to investors during its remaining life this is known as intrinsic value. This is a key concept here that everyone should really keep in mind as we go through this. So now let's bring stocks back into the equation and understand what we're paying and what we're getting? When we purchase a stock we're paying in cash, the stock price quoted on the stock market in return we get a proportional ownership that each stock represents an underlying company. And this piece of ownership represents the proportional claim on all of the cash that can be taken out of the business during its remaining life. This includes the company's existing cash which is the cash it has already generate and just sitting in the bank accounts. As well as all the future cash that the company will generate going forwards the cash.
Here we're talking about are the free cash left over after paying for all the operating expenses to run the business and repaying the debt investors. The amount of cash that a company is free to give back to shareholders and still keep the business running price is what we pay and value is what we get. So let's think about that for a minute if the value of all these cash that we're getting is higher than the stock price we're pay and that's a pretty good investment. In other words we're paying a price below the intrinsic value and we're profiting from the difference. Let's illustrate with an example, suppose, there's a company that has a thousand dollars in its bank account, for simplicity let's assume and stop doing business so it doesn't have any future cash coming in and the $1,000 in the bank account is pretty much all that it has it has. It has 100 shares and the owner is willing to sell us each share in the company for five dollars, in this example should we buy the stock? The answer should be yes. Of course we should buy the stock. There's a thousand dollars of cash we're getting which is a thousand dollars of intrinsic value. There's a hundred shares so each share has a value of ten dollars per share the owner who probably didn't take this course is offering to sell us each share for five dollars so we're paying five dollars for a stock that entitles us to ten dollars of cash in return.
We’re effectively buying a ten dollar bill for just five dollars that sounds like a pretty good investment and we should buy the stock. On the other hand if the owner is trying to sell us each stock for $20 per share should we still buy the stock? No, we shouldn't because that's like saying we want to pay $20 for a ten dollar bill but anything lower than $10 per share which is the intrinsic value would make sense for us. This is the general idea of what we're doing when we analyze a stock. We're trying to figure out how the intrinsic value compares to the stock price but profiting from the gap between price and value is just half the story. That's because intrinsic value doesn't stay constant. It's not like a company has one particular intrinsic value that stays constant throughout its lifetime, it doesn't. Intrinsic value changes over time, fundamentally strong businesses are much more likely to benefit from future increases in value whereas poor low-quality businesses are bound to see their value chipped away. That's why we don't just look for stocks priced below intrinsic value but specifically stocks of high quality businesses price.
The risk with investing a fundamentally low quality business even if we purchase it below intrinsic value is that whatever excess value that exists at the time of our investment, could be wiped out during our holding period. As the intrinsic value declines over time but by investing in high quality businesses at prices below intrinsic value we profit on two fronts. We profit from the gap between intrinsic value and price and we get the additional kicker from future increases in value. This is the essence of fundamental analysis this is the same approach that Warren Buffett preaches and the recurring theme of team.
So now we've established logically that the stock investing strategy is to investing stocks of high quality businesses at prices below intrinsic value but we make money in the stock market by buying low and selling high the stock price has to go up. In order for us to make money logically some of us will ask what does intrinsic value have to do with the future share price? This is really a key question and we're going to show how the stock prices will in relation to intrinsic value in the next blog.
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