WHAT IS INTRINSIC VALUE? Why Is It Important?
As many people in my network already know, Warren Buffett is one of my favorite people. I have read nearly every piece of literature on the man, and hope to one day spend a few minutes picking his brain.
One thing Warren frequently references regarding investing, is Intrinsic Value. As I read the recent Berkshire Hathaway Annual Stakeholder letter, I thought this is something that I would shed some light on how it affects my life.
INTRINSIC VALUE: 1. FIRST LET’S DISCUSS THE DEFINITION OF INTRINSIC VALUE
“The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors.” (Investopedia)
When thinking about Intrinsic Value, we consider the Tangible and Intangible factors that determine the worth of a company, and in my life how I value people. Even in Berkshire’s Latest Stakeholder letter, Warren discusses the fact that Intrinsic Value is a number that is hard to measure precisely.
“As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate.”
The hard math used in calculating the objective factors is much easier to determine than an intangible factor.
INTRINSIC VALUE: 2. WHAT ARE THE TANGIBLE FACTORS OF A BUSINESS?
- Buildings and Land
The value behind the hard product or service is the first place to start. How does a business impact the lives of the people it serves?
I often think about the price of this product and or service and how it relates to the profitability of a business. Especially based on how many sales can be generated, and how it relates to benefits received by the customer.
After establishing these fundamentals, time to think about the machines and infrastructure we will need to create the product, deliver the service, and where we will the headquarters and potentially warehousing exist.
Next, we evaluate how much cash we have to float business operations and marketing over the next few business cycles. Do we need to seek outside capital?
Finally, I like to evaluate how much debt will need to be taken on and how much equity is retained by the company? Do we own any real estate? Are the products and services owned or contracted out through 3rd party suppliers?
Once we have information on all of these tangible factors, we can do some math to decide whether or not we have a viable business idea. At least from a quantitative perspective.
INTRINSIC VALUE: 3. WHAT ARE THE INTANGIBLE FACTORS OF A BUSINESS?
- Networks & Relationships
- Brand Reputation
- Software Capabilities
- Trade Secrets
Networks & Relationships are assets that businesses leverage to create more demand for the company’s products and services. One of the best forms of marketing is word of mouth.
Brand Reputation is one of the most important factors to consider, especially how it relates to your network and your relationships. Your business is more likely going to generate more referrals if you are providing a quality product/service and excellent customer experience.
Software Capabilities are a significant benefit when scaling a business or trying to create a proprietary solution for customers. If your company has a system in place that can quickly scale up to a million-plus customers without too much investment, you are one step ahead of those who have antiquated systems that won’t be able to support that kind of growth.
Trade Secrets are essential and not very accessible. Such as the spices in KFC’s chicken recipe, or a High-Frequency Trading firm’s algorithms for executing trades. These pieces of information can be a business’s competitive advantage and provide the right edge to be successful.
INTRINSIC VALUE: 4. WHAT ARE THE TANGIBLE FACTORS IN PEOPLE?
People have tangible assets. Like the education they have received, the skills they have developed, and their past accomplishments. It is difficult to assess the value someone can bring to the table unless we give credit and weight to these different areas.
For instance, someone who has recently graduated from a respectable college with an MBA. What if they haven’t done anything in life or developed too many hard skills? What if they dropped out and built a company like Facebook?
More often than not as we grow older this weight shifts to the things we have accomplished – which likely means we can tap into these prior accomplishments and reproduce similar results or perhaps build on our achievements.
If you can put these two forces together, you may have something extremely valuable.
INTRINSIC VALUE: 5.WHAT ARE THE INTANGIBLE FACTORS IN PEOPLE?
- Work Ethic
These two intangible assets within people are strong indicators of what they can accomplish in their life. If someone is capable of putting in the hard work necessary to be successful, while maintaining a positive attitude when obstacles and disappointment are present, they will create their own success.
You should always seek to find these people and bring them on your team. They are the ones who focus on finding solutions to problems and will take the action necessary to reach goals.
INTRINSIC VALUE: 6. WHAT DOES THIS ALL MEAN?
In the end, life moves pretty fast and we don’t always have all the time we’d like to evaluate the decisions we make. If you can learn to see through the fluff and analyze things on their intrinsic value, you will see a higher return on your investments.