What is Intrinsic Value?
Intrinsic value is the estimated worth of a company based on the present value of all future cash flows it will generate. Pioneered by Benjamin Graham and practiced by Warren Buffett, this concept holds that stock prices fluctuate around intrinsic value in the short term but converge to it over the long term. The gap between market price and intrinsic value creates investment opportunities.
How to Calculate It
The standard method is discounted cash flow (DCF) analysis. Project free cash flows for 5-10 years, estimate a terminal value for all subsequent years, and discount everything back to present value using the weighted average cost of capital (WACC). For a company with $10 million annual FCF, 3% growth, and 8% discount rate, the terminal value is $10M / (8%-3%) = $200 million. Multiple scenarios with different assumptions provide a range rather than a single number.
The Margin of Safety
Since intrinsic value calculations involve numerous assumptions, Graham recommended buying only at a 30-50% discount to estimated intrinsic value. If you calculate intrinsic value at $100 per share, only buy below $70. This margin of safety protects against analytical errors and unforeseen events, turning an imprecise estimate into a practical investment framework.