What is Intrinsic Value?
There is an objective, determinable value for any investment, which is independent of the stock market. This is known as its intrinsic, real or true value, and is defined as “the discounted present value of all the cash that can be taken out of a business during its remaining life”.
This universal value formula is applied to valuing bonds (government or corporate debt issues), when sold in the market before their maturity date. The formula actually applies to all investments be they bonds, stocks, real estate, commodities, works of art, or government bonds. With bonds the interest rate and maturity amount are known. With stocks they have to be estimated.
The discount rate is the compound interest rate in reverse. A dollar today (the present value) is worth more than a dollar to be received in 10 years, because interest can be earned on the dollar today and it will therefore compound and grow to more than a dollar in 10 years time. Similarly, if cash is exchanged today for a dollar due in 10 years, it will be “discounted” back by the interest that could be earned by having the dollar today. When valuing a business the interest rate used to do the discounting, is the “risk free” long term government bond rate. That is why a movement in interest rates is so important, because it affects the value of all investments. However, judgement is required here if the government bond rate is considered to be abnormally high or low.
Too confusing! The important thing is to have the concept in mind, even if you can’t do the math. In more simple terms, the higher the income from the investment, and the more it will grow in future, the more valuable the investment is today.