Market Value and Intrinsic Value Are Not the Same Thing

A Single Insight That Can Help Rational Investors Build a Fortune

Intrinsic Value and Market Value Are Different
The market value of an asset, be it a share of stock, a bond, real estate, song rights, or anything else, does not always reflect the intrinsic value. Therein lies an enormous opportunity for rational, disciplined investors who can control their emotions and think with cold impartiality. Biddiboo / Photographer's Choice / Getty Images

Although so-called "hard" efficient market theory has largely been discredited as academic nonsense thanks to the rise in the far more accurate real-world behavioral finance approach (humans are not always rational, they do not always pay reasonable prices for assets, and markets are not always reflective of economic reality for a variety of reasons), when stock prices begin to fall, inexperienced investors sometimes freak out because they don't understand that every asset has two prices:

  1. The intrinsic value: The approximate net present value of the after-tax, inflation-adjusted discounted cash flows between now and the end of time
  2. The market value: What other people are willing to pay you for the asset at any given moment

The intrinsic value and the market value often line up over time because people are mostly reasonable when life is calm and there's nothing strange going on in the world, but there can be periods or conditions under which they diverge wildly.

You know this on some level, whether you realize it or not. Imagine you own a seasonal ice cream stand near popular ballfields in a major city. From selling shakes, malts, banana splits, ice cream cones, hot dogs, and Coca-Cola, it produces $30,000 a year in after-tax income on net tangible capital of $30,000; a mouth-watering 100% return. Every summer, you hire a few teenagers to run it, make sure things are going alright, and collect the stream of earnings.

It's never going to grow much beyond inflation, but it's a lucrative, if small, operation.

Now, imagine someone approaches you and offers you $5,000 to buy it. You'd laugh in their face. Why? Even if you haven't bothered to perform the actual intrinsic value calculation, you already know the market value he or she is offering is a mere fraction of that intrinsic value.

There is no way you're going to accept something so inappropriate. Now, picture this person offering you $3,000,000. You'd jump on it in a heartbeat because even without taking out a calculator, you know the market price that is being offered far exceeds the intrinsic value. You could never make that much from the ice cream stand so you're better off taking the cash and investing it in something else.

All productive assets in the world are the same way. Stocks are merely proportional ownership in businesses like the ice cream stand. You have to look at what you're getting for the market price at any given moment (and not be quick to sell a great holding just because the market price might exceed its intrinsic value at any particular time; the real money - the life-changing, generational wealth - is more often made by holding fantastic cash generators over 25+ year periods, not trading). If you doubt it, I'd argue you aren't paying very close attention to math or history. How many people bragged about a quick 20% gain buying a firm like Coca-Cola at one price and selling it at another, constantly trying to flip it as if it were a piece of rundown real estate? Instead, had they parked a single $10,000 lump sum in it on the day I was born, reinvested their dividends, and done nothing else, they'd now be sitting on $1,020,939 in stock, have watched their position rise by 10,109.39%, and enjoyed a 15.09% compound annual growth rate.

If they'd dumped $10,000 a year into those crisp, green stock certificates for the Atlanta-based juggernaut, the numbers would be breathtaking.

Even if you occasionally experience a business bankruptcy, as you are statistically likely to do, you can still make money in a well-diversified portfolio as a result of the mathematics of diversification. To provide a real-world illustration, a long-term investor in a firm like Eastman Kodak at the time it was enjoying the height of its reputation wouldn't have walked away empty-handed despite the stock going to $0 due to the dividends and spin-off of the chemical division. (The exact degree of loss depends on whether you reinvested the dividends back into Eastman Kodak itself or the portfolio as a whole. The risk / reward trade-off between the Coca-Colas and Eastman Kodaks of the world can be bridged through the use of portfolio rebalancing.)

How I Focus on Intrinsic Value for My Own Household, Business, and Other Portfolios Under My Stewardship

Whether it is our own, personal household portfolios, the portfolios of the operating companies we own and control, or the portfolios of family and friends who have asked us to look after their financial well-being by managing their life savings, in our neck of the woods, we have several strategies for keeping the focus where it should be: Acquiring as much intrinsic value as we can then sitting on it for decades. It's a philosophy that served us extraordinarily well and allowed us to achieve financial independence much younger than many on the journey.

  • As the real-time spreadsheets update showing us exactly what is invested where, each ownership stake in a business highlights our proportionate share of sales, profits, dividends, and retained earnings, along with the market value. The column listing market value is actually named "Mr. Market" from Benjamin Graham's famous analogy. Unless our fictional business partner is offering us extraordinarily favorable terms to our sell our stakes, we aren't interested. In some cases, we aren't interested in selling at all (as has often been quipped by legendary investors, including Warren Buffett, with what firm could you possibly replace Coca-Cola and receive the same certainty it is going to do well in the coming century?). There are also columns showing our earnings yields and dividend yields so on days when the markets collapse, we start seeing rising future returns, making our positions more attractive as long as the underlying business remains intact.
  • We always ask ourselves about each company in which we maintain an investment, "How does this business make money? What are the factors that make it possible? What are the things that threaten it? What are the opportunities to make more? What is the likelihood of an enjoyable experience as an owner given the price we must pay relative to the owner earnings?" If we can't tell you where the cash is coming from and how it makes its way into our hands, we say, "Thanks, but no thanks."
  • We regularly review the portfolio and ask ourselves, "If the stock market were to close for the next five years, and we couldn't buy or sell anything, would we sleep well at night owning what we do, in the amounts we do?" If the answer is, "No", changes are made. Crazy things happen, ranging from terrorist attacks to the outbreak of world war. While some might prefer to live dangerously, my husband and I both grew up without a silver spoon and had to work our way through college, the first in our families to get degrees. We're keenly aware of the old adage, "You only have to get rich once". We have no desire to "go back to go", as it were. By making it our first priority to never lose money, we can separate fluctuations in market value (seeing a particular business down 40% on paper, which often doesn't mean much) from intrinsic value (seeing the economic engine fall apart at a business due to changes or firm-specific problems, which forebodes real, permanent losses). A classic example: Look at what is happening to shares of the oil majors right now, which I wrote about extensively on my personal blog. Blue chip stocks like ExxonMobil have crushed the S&P 500 over the past 30 years, even with the ending period measured at the recent free fall in crude (which tells you how substantial the outperformance was) but, along the way, you had to spend periods of 3, 5, or 7 years where you saw 25% to 50% losses on your brokerage statement.
  • We have spent our entire careers studying things like GAAP rules and corporate finance. We use those skills to dig into the 10-K filing and the annual report looking for warning signs, like aggressive accruals relative to reported net income or questionable practices such as inadequate loss development reserves at property and casualty insurance companies. There are times we'll pass on a business that otherwise looks reasonable because there's something that leaves us feeling uneasy buried hundreds of pages into the disclosures.
  • Though we're not dividend investors per se - we've made a lot of money buying stocks that don't pay dividends - we can be patient if it takes years for our thesis to work out because more often than not, we sit back and collect streams of cash, eventually getting our stock for free thanks to dividends, which act like rebates on the purchase price, returning capital we laid out and letting us deploy it elsewhere. You can't fake cash. The check either arrives or it doesn't. The amount paid on each share either increases faster than the inflation rate or it doesn't.

Taken together, it helps us keep our attention on what really matters. We don't lose sleep when the stock market crashes. We are always aware of how much cash we keep in our portfolio. We tend to avoid margin debt in most situations and never utilize it to a degree it could be a problem. We also own the firm, which means no one can fire us if we want to take 5-10 years to hang on to a good idea that might look ugly on paper for awhile. We've arranged our entire portfolios and lives around systems that let us take advantage of rational long-term behavior. You can, too, if you really desire it.