How To Determine Intrinsic Value Of Any Company In 5-10 Minutes
No Harvard MBA Is Required
In the last chapter we took a closer look at how the margin of safety works and what kind of things we should look for in order to make a proper value investment. As previously discussed, one of the most important things to know when figuring out the true margin of safety is the Intrinsic Value (IV) of any given company.
Wikipedia defines Intrinsic Value as the actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.
Now, there is something very important you must understand. Determining the IV of any company is arbitrary at best. It could be a highly complex process involving hundreds of excel sheets and data points or it could be a fairly easy process involving a few easy to understand middle school algebra calculations. At the end of the day, neither approach will give you an exact IV of any company.
Why? Because we are dealing with the unknown. What we are doing when we are determining an IV of any company is taking various existing data points and projecting them well into the future. In fact, most models call for at least a 5 year discounted cash flow projection to value a company. The problem is, the future is unknown and in the fast paced business world everything can change on the dime. Making your original IV calculation obsolete.
New products, new technologies, new competition, economic booms and busts, political developments, regulations, etc….. and the list never ends. How can we make an accurate IV calculation when so many different “unknown” factors can impact your model. Well, we cannot.
We can make our best estimates, but we can never achieve a 100% proper IV valuation for any given company. Give 10 different analyst a company to value and they are likely to come up with 10 different answers. Most likely within +/- 20% of each other. The point I am driving at is this. There is no possible way to achieve perfection when it comes to IV calculation. We are dealing with too many unknowns and future developments. All we can do is estimate.
Let me give you a quick example. Why did Investment Banks who were involved in the Facebook IPO (initial public offering) valued the company at $38 a share? Did these Investment Banks have a bunch of complex and secret valuation algorithms valuing Facebook before the IPO. It’s probable, but not likely. You see, whatever number any such valuation yields would technically be garbage because the future of Facebook is unclear. It is a fast growing tech company, but without a clear path. Everyone is making assumptions. No one knows if Facebook will grow at 20% per annum over the next 10 years or make a series of mistakes that will put it on the path previously walked by MySpace.
As such, everyone can make estimates in order to derive the IV, but in reality no one truly knows. Anyone who claims they can properly determine the IV value of Facebook is simply lying. What ends up happening in a situation like this is investment bankers basically figure out what “the market” is willing to pay and set their IPO price based on that.
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