What is Intrinsic Value?
The intrinsic value of a business or investment, is deemed to be the present value of all expected and predicted future cash flows which have been discounted at an appropriate discount rate. This is similar in concept to a Discounted Cash Flow model. Unlike many other forms of valuation technique, this doesn’t look at comparable companies, and instead looks at the value of a business by itself.
Risk Adjusted Intrinsic Value
You can adjust cash flows in terms of their risk. However, the task is incredibly subjective and is somewhat an art and a science at the same time.
There are two key methods in order to do this. The discounted rate, and the certainty factor:
- Discount Rate: You can use a discount rate which includes a risk premium in order to discount the cash flows over the period. This rate will depend on several variables which you’ll need to match to your scenario
- Certainty Factor: The certainty factor is based on a scale of 0-100% and is the basis for the certainty that the cash flows in the forecast will actually materialise. This approach is supposedly used by Warren Buffet according to his annual letters to shareholders.
Discount Rate
With this approach, an analyst will use a company’s weighted average cost of capital. This formula will include a risk-free rate (which is normally based upon a government bond yield and deemed to be ‘free of risk’) as well as a premium based on the volatility of the investment. This is then multiplied by a risk premium.
The logic behind the discounted rate approach is to flatten the variety in a valuation when considering the volatility of the investment. The more volatile, the riskier the investment, and therefore this method will take that into consideration when considering the value.
Certainty Factor
The certainty factor could also be referred to as the probability that cash flows will occur. In this method, only the risk-free rate is used as a discount rate. The certainty factor will be lower the higher the risk of the investment.
For example, a government bond will have a certainty factor of 100%, while a tech company may have a certainty factor of 50%.
When comparing the discount and certainty methods, they’re essentially doing the same thing in a different way. They’re both discounting cash flows based on the inherent risk the investment brings with it.
Challenges with Intrinsic Value
The core problem with calculating intrinsic value is the level of subjectivity in the exercise. There are many assumptions which need to be made, and there are some very sensitive fluctuations based on the assumptions made.
By definition, predicting future cash flows is uncertain. For this exact reason, many successful investors can all value a company using these methods, and reach a different conclusion on the value of a company/investment.
