Intrinsic Value

One of the essential conditions of preserving capital is developing a profound understanding of the value of individual investments. As consumers, we don’t buy a car or a refrigerator without having an idea of their value. Only then can we compare what we get in terms of functionality, appearance, and other attributes with what we pay. This allows us to make an informed judgement about the merits of a purchase.

We are convinced that this fundamental concept is equally relevant when it comes to investing. When investing in stocks, we are essentially acquiring stakes in companies. Therefore, evaluating the merits of a stock investment requires comprehensive knowledge about the value of the underlying company, often referred to as its intrinsic value.

Price does not always equal value

To be sure, a company’s value often differs from the price assigned to it by stock markets, though not always. What we pay for a company’s stock can fluctuate a lot as markets rise and fall. However, typically, a company’s intrinsic value remains far more stable than the price swings in the stock market might lead you to believe. In other words, stock prices are an imperfect indicator of a company’s intrinsic value.

The reason for this is that short-term movements of stock prices are often influenced more by human emotions than by rational assessments of the fundamental factors impacting the underlying value of a company. Having a comprehensive understanding of a company’s intrinsic value not only provides investors with peace of mind during volatile times but also enables them to benefit from opportunities that markets regularly present.

Volatility provides opportunities

While short-term swings in stock prices are often much feared, we believe an investor shouldn’t lie awake at night worrying about them. A big fall in share prices may feel very painful at that time, however it often reveals surprisingly little about what is happening at individual companies, let alone what they are worth.

Volatility in stock prices is also feared for another reason. When an investment manager’s performance is regularly measured against an index, the last thing this manager wants is to suddenly underperform that index. To minimize the potential for surprises caused by market volatility, the safest course of action for this manager is to stay close to the index composition, without any regard to the value of his investments. Needless to say, index investing completely ignores the concept of intrinsic value.

True value investors can benefit from price volatility in stock markets. High price volatility increases the odds of mispricing, creating opportunities to buy or sell on favorable terms. The key lies in the ability to differentiate between temporary and permanent capital losses. A  temporary capital loss often occurs due to general stock market fluctuations or frenzied trading following company news. Temporary losses are typically transient and can be recovered as markets rebound or as the impact of company news is carefully analysed.

In contrast, a permanent loss of capital arises when a company is structurally worth less than initially assessed, often due to a deteriorating competitive position or other structural issues. To distinguish between these two types of losses and avoid making poor investment decisions based on emotions, it is essential to develop a clear understanding of the intrinsic value of your investment.