Intrinsic Value Explained

(This piece was adapted from a classic Fool article.)

Imagine you're looking at a newfangled invention called the "dollar machine." Once a year for 10 years, it spits out a brand-new dollar bill. How would you value this contraption? Obviously, a price tag higher than $10 is silly. Paying $9 might seem smart, as it locks in a $1 profit. But you can do better with your $9.

Think of it this way. (Warning: Math crossing next two miles.) If you invest $9 for 10 years and it turns into $10, you've achieved a total return of 11.1%. That might look good, but it's 11.1% over a 10-year period. It amounts to only about 1% per year. Jeepers -- even a passbook savings account might beat that, and it's insured, too. Investors should always consider where else they might plunk their greenbacks, and what other kinds of returns they might expect.

Back to our dollar machine. Let's say you expect a rate of return equal to the stock market's historic rate of about 11% growth per year. If so, you might decide to pay just $3.52 for the machine. That $3.52 invested for 10 years, earning 11% annually, becomes $10. If you expected to earn a 6% annual rate of return, you'd likely value the machine around $5.59. (You would probably be outbid by someone else, though... someone who realized that he or she could reinvest those dollars elsewhere at the end of each year.)

The dollar machine is not just a fantasy. It's very much like companies in which you buy stock. The price you'd pay for the machine is its "intrinsic value." Companies also have intrinsic, or fair, values that are based primarily on earnings, and investors need to keep this in mind when buying stock in them. Pay attention to a company's earnings and dividend payout.

If you bought a share of General Electric (NYSE: GE  ) in 1990, it would have cost you about $6. In the 10 years from 1990 to 2000, it paid out more than $6 in dividends. Was the $6 a good price, then? Well, considering that GE stock split 2-for-1 in 1994 and again in 1997, split 3-for-1 in 2000, and recently traded around $35 per share, you betcha. (Note, though, that GE shares are down considerably from their peak north of $55 back in 2000.)

Companies are valued on the profits they earn. When buying stock, you don't want to end up paying too much for a dollar machine.


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  • Report this Comment On July 12, 2012, at 9:04 PM, Prince40 wrote:

    Selena,

    I found your example in the book I am reading right now about Warren Buffett, "Warren Buffett Wealth", page 56.

    Great example, but I have to say that your calculation of $3.52 for "dollar machine" is incorrect.

    The correct amount to pay for the machine and to earn 11% anual return is $4.75........

    .........and here is how:

    if we asume that our machine spits out $1 a year for 10 years that would give us a revenue of $10. Now, the cost of the machine would have to be $4.75 (assumming that there are no maintanance costs) giving us a profit of $5.25. That is 110% return on our invested $4.75 over 10 years and 11% per year.

    If we assume that we paid $3.52 for the machine that would leave us with a profit of $6.48, which would give us a return over 10 years of 184% or 18.4% per year. The differnce between your calculation comes from the assumption that every year the profit is reinvested (compounded interest), but that is not assumed in your example. The owner of the "one dollar machine" has three choices when it comes to the profit he gets every year:

    1. simply keeps it and doess nothing

    2. spends it they way he likes it

    3. Reinvests every dollar earned by purchasing another "one dollar machine", which would give him the higher return of 18.4% as you calculated.

    I would love to know think what you or any other Motley Fool staff think about it and I hope that any other reader will find it useful.

    Sincerely,

    Prince......:))))))

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