Intrinsic value

Intrinsic value, sometimes abbreviated IV, is the value contained within a security. This can be thought of what the security is, or, as one would find, should be, worth to hold onto during its remaining life. By holding an investment one expects to realize value -- get money -- in the future. This is why people pay money to own a stock or a bond.

The intrinsic value of a stock, bond, real estate property, business acquisition, option, warrant, contract, or any investment prospect is equal to the value of the cash flows one expects to put into and take out of that prospect during its remaining life, discounted at an appropriate rate. For a share of stock, cash flow means dividends, after taxes, that one expects to receive. For a bond issue, cash flows means interest payments, after taxes, and principal repayments that one expects to receive. For real estate, cash flows means rental income, after associated costs and taxes, that one expects to receive. For an option, cash flow means after-tax profit realized from exercising the option at the expiration date. And so on...

Notice two things:

1. We are only concerned with after-tax value (more on this in another post)
2. Liquidity of the issue is not mentioned (that is not to say it isn't important, but liquidity of an issue only affects the cash flows one can realize by owning that issue in subtle ways out of the scope of this post -- though it may be explained in a later post)

As for the appropriate discount rate, theoretically one should use the expected return of one's best available alternative. Another way -- and this part of investing is more art than science (though others, unsuccessfully in my view, try to make it science) -- is to use an easily identifiable risk-free rate, for example the yield on long-term bonds issued by stable governments, plus an extra allowance for risk assumed. Many investors use 8-12% as their discount rate -- but this depends greatly on the application and should be used as a guide and not a rule.

A quick but "mathy" example: If one applies a 10% discount rate to a prospective investment which will yield $1M at the end of the first year, $1.03M at the end of the second year, and so on increasing at 3% per annum forever, then the intrinsic value of the investment is about $14.3M. We derive this by using the formula for an infinite geometric series: (a0 / (1 - r)). In our case, a0 is $1M/1.1 or about $0.91M (since it pays out at the end of the first year). r is 1.03/1.1 -- the growth rate divided by the discount rate.

Now we have a definition of IV that we can move forward with.