What Is Intrinsic Value? The Worth Behind the Price

What is intrinsic value?

Intrinsic value is what a business is worth to the person who owns it: all the cash it will produce over its remaining life, discounted back to today. It is a property of the business itself, not of the market. The stock price tells you what strangers will pay for a share this afternoon. Intrinsic value tells you what the share will pay you for holding it.

Warren Buffett put the distinction in nine words in his 2008 letter: "Price is what you pay; value is what you get." Berkshire's owner's manual defines the term in the same spirit. Take every dollar the business will hand its owners between now and the end, discount each one back to the present, and the total is what the business is worth. Everything else in this module builds on that definition.

A rental duplex makes it concrete. If the building nets $20,000 a year after taxes and upkeep, its value flows from that stream of rent, not from whatever number a neighbor shouted over the fence this week. You might reasonably debate what the stream is worth. You cannot sensibly value the building without looking at the rent. A stock works the same way, and the rent is the cash the company generates.

The gap between the two numbers is where investing happens. When price sits far below a careful estimate of value, you have found something worth investigating. When it sits far above, you have found something worth avoiding, however admirable the company.

Why value is future cash, discounted

A dollar the business will earn in ten years is worth less than a dollar it earns this year, and discounting is the arithmetic that accounts for the difference. Money arriving later is worth less for two reasons. You could have invested an earlier dollar in the meantime, and the later dollar is less certain to arrive at all.

Intrinsic value = sum of future owner cash flows / (1 + r)^t

Here r is the discount rate, the annual return you require for tying up your money and bearing the risk, and t is the year each cash flow arrives. The formula compresses a lifetime of business results into one present-day figure.

A no-growth example shows the scale. Say a business will reliably hand its owner $8 per share every year, forever, and you require an 8 percent return. Its value is $8 divided by 0.08, which is $100 a share. If the stream also grows, the shortcut becomes

Value = next year's cash flow / (r - g)

where g is the long-run growth rate. The year-by-year mechanics of projecting and discounting are the subject of discounted cash flow. The point here is simpler: value is future cash translated into today's dollars, which is also the foundation of value investing as a discipline.

The discount rate r is your own standard, not a law of nature. Most investors set it between 8 and 12 percent for established businesses, using the higher end when the future is harder to see. What matters is consistency: value every business against the same bar, and let the bar reflect what your money could honestly earn elsewhere.

What are owner earnings?

Owner earnings are the cash you could take out of a business each year without weakening it, and they are the stream worth discounting. Reported net income is an accounting result, shaped by non-cash charges and estimates. Cash is what actually piles up in the owner's pocket, and the two can diverge for years.

Buffett laid out the idea in the appendix to his 1986 letter. Start with reported profit, add back depreciation and other charges that consume no cash, then subtract the capital spending needed to keep the business running at its current strength.

Owner earnings = net income
               + depreciation and other non-cash charges
               - maintenance capital spending

Say a company reports $10M of profit, recorded $3M of depreciation, and must spend $4M a year replacing equipment to stay competitive. Its owner earnings are $10M plus $3M minus $4M, or $9M. That $9M is what an owner could pocket each year without eating the business alive.

Two neighboring ideas are worth knowing. Free cash flow is the practical cousin you can compute from any cash flow statement, and the split between maintenance and growth capital expenditures is the judgment call hiding inside the formula. A company spending heavily to grow can show thin free cash flow while its owner earnings are perfectly healthy.

Why is intrinsic value a range, not a point?

Because every input is a judgment about the future, an honest valuation produces a band of outcomes rather than a single number. You are estimating growth, margins a decade out, and the right discount rate. Small, reasonable disagreements on each compound into large gaps in the answer.

Run the $8-per-share business through three defensible growth assumptions at a 10 percent required return:

The figures are hypothetical and rounded. Nothing about the business changed between the rows, yet a two-point swing in assumed growth, well inside the range serious people could defend, moves the value from $80 to $133. The spread is not a flaw in the method. It is the honest shape of the answer.

This is why a model that prints value to the penny deserves suspicion. The decimals imply a precision the inputs cannot support. Two careful analysts, working honestly from the same filings, will land in different places, and both can be defensible. Professionals state the output as a range and do their thinking from the low end of it.

The width of the band is itself information. Predictable businesses, a utility collecting regulated rates or a subscription service with years of renewal history, produce narrow ranges. Businesses hostage to commodity prices or fashion produce wide ones. And when your own range spans more than about two to one, the honest conclusion is usually that the company sits outside what you can value, which no discount cures.

How do investors use an intrinsic value estimate?

You use the estimate by comparing it with the price and acting only when the gap is wide. The estimate does not need to be exact to be useful. You do not need precise scales to see that one suitcase is far heavier than another; rough bounds are enough, provided you insist on a real discount before acting.

With the range above, a disciplined buyer treats $80 to $133 as the working band, centers on $100, and then refuses to pay anywhere near it. Paying $70 puts you 30 percent below the base case and below even the cautious scenario. That discount is the margin of safety, the buffer that absorbs the errors your estimate almost certainly contains.

It also helps to keep the concept clean by naming what it is not. Intrinsic value is not book value, the accounting net worth sitting on the balance sheet. It is not an analyst's price target, which guesses where the quote might travel next. And it is not what you paid, a number the business neither knows nor honors. It is the discounted worth of the future cash, nothing else.

Remember, too, that intrinsic value moves. A business that reinvests at high returns is worth more each year, so an estimate is a snapshot, not a verdict. Revisit it as results arrive and let the range shift with the facts. The practical routes to producing the estimate, from quick multiples to full models, are mapped in how to value a company.

Where to go from here

Intrinsic value is the anchor; price only means something when you have an independent estimate of value to hold it against. See how price and value combine into a judgment in when a stock is undervalued, and keep a margin of safety between your estimate and what you pay. When you are ready to look for candidates, the Tenet screener surfaces businesses trading below a defensible sense of fair value.