What is Intrinsic Value? How Do We Understand It?

Okay, let's talk about this "intrinsic value." It's essentially the cornerstone of value investing. I'll explain it to you using down-to-earth language.

What is Intrinsic Value? A Straightforward Explanation

Imagine you go to a market to buy an apple.

The seller asks for 5 yuan… this “5 yuan” is its Price.
But what is the apple really worth? It’s very sweet, juicy, big, and will give you enjoyment and nutrition. In your mind, you feel it's worth at most 3 yuan. That "3 yuan" is your estimate of its Value.

Intrinsic value, in simple terms, is what a company or asset is "truly worth" by itself, completely independent of what people in the market are currently willing to pay for it (i.e., its stock price).

This is one of the most fundamental ideas in investing, introduced by Benjamin Graham (Buffett’s mentor) and championed by Warren Buffett. Remember this famous quote:

“Price is what you pay, value is what you get.”

The secret to investing success is buying high value at a low price.

How Do We Understand and Estimate This “Intrinsic Value”?

You might ask, an apple's value is easy to think about, but a company's "intrinsic value" seems vague—how do you calculate it?

You're right; it can't be calculated with pinpoint accuracy. It's always an estimate, a range. But experienced investors use several approaches to approximate this "true value." Think of it primarily in two ways:

Method 1: The "Money-Making Capacity" Estimate (Formally: Discounted Cash Flow - DCF)

This is the most mainstream, and Warren Buffett’s favorite, method.

Core Idea: A company is worth something because it can continuously generate profit for its shareholders in the future. The intrinsic value is the sum of all the money this company is expected to earn over its lifetime (even decades), converted into today's dollars.
An Example: Imagine a "money-printing machine" (a company). You know it will “print” 100,000 yuan next year, 110,000 yuan the year after, 120,000 yuan the next... right up until it stops working.

How much would you pay to buy this machine?

You definitely wouldn't pay the sum of all that future profit. Why?
1. The Time Value of Money: 100,000 yuan next year is worth less than 100,000 yuan today because money today can earn interest in a bank.
2. Risk: Who can guarantee the machine won't break down? (Company performance might deteriorate).
So, you need to apply a "discount." For example, you discount future money by 10% each year to get its present value. The sum of all these discounted future sums is the maximum price you’d pay for the "money-printing machine," representing its intrinsic value.

This is why you always hear about the DCF (Discounted Cash Flow) model in financial analysis – this is the concept. You don't need to calculate the complex formula, but you must grasp the core idea: A company's value stems from its future profitability.

Method 2: The "Pawn Shop" Estimate (Formally: Asset-Based Valuation)

This was a preferred, simpler, more direct method used earlier by Benjamin Graham.

Core Idea: If the company shut down today, went out of business, sold off all its assets (factories, equipment, cash, inventory), and paid off all its debts (bank loans, payables), the leftover money would be the company's intrinsic value.
An Example: Take that fruit stand again. Suppose the owner wants to quit. Let's liquidate:
- Assets: A tricycle (worth CNY 500), a digital scale (CNY 100), unsold fruit today (CNY 200), cash in the drawer (CNY 300). Total Assets: 500 + 100 + 200 + 300 = CNY 1,100.
- Liabilities: Still owes CNY 100 to supplier Old Wang for the morning groceries.
- Liquidation Value (A form of intrinsic value): 1,100 - 100 = CNY 1,000.
If someone sold you this fruit stand for CNY 800 right now, that would be a great deal.

This method is particularly suitable for companies with substantial physical assets, like banks, insurance companies, or heavy industrial firms. This is also why many people analyzing bank stocks look at the Price-to-Book ratio (P/B) – "Net Asset Value" embodies this idea of the "hard assets."

You Understand Intrinsic Value... Now What? The Key is the "Margin of Safety"

Calculating intrinsic value isn't about precision; it's about finding a Margin of Safety.

This is the essence of Graham's thinking!

What is a Margin of Safety? It's the difference between your estimated intrinsic value and the price you actually pay. The bigger this gap, the safer your investment, and the higher your potential future return might be.
The Classic Example: A bridge is designed to hold 30 tons, but only allows vehicles under 10 tons to cross. This gap of 20 tons is the "Margin of Safety." It ensures safety even if your calculations were wrong, the materials had flaws, or a vehicle was slightly overweight.
Applied to Investing: You carefully analyze and estimate a company's intrinsic value to be around CNY 100 per share. You wouldn't buy at CNY 100, or even CNY 90 might feel risky. But if, due to market panic, the stock price crashes to CNY 50, a vast Margin of Safety now exists between intrinsic value (CNY 100) and market price (CNY 50). Buying now gives you significant room for error and a higher probability that the price will eventually rise towards its value, increasing your chances of profit.

To Summarize for You

Intrinsic Value is what something is "intrinsically worth," separate from its current market price.
Estimating intrinsic value focuses on two main things: its future profitability (Discounted Cash Flow) and its current net worth (Asset liquidation).
Estimating it isn't about getting an exact number, but deriving a reasonable range. Investing is an art, not a pure science.
The heart of investing is buying only when the price is well below your estimated intrinsic value, creating a sufficient Margin of Safety. This protects you from big mistakes and makes profits more likely.

Understanding intrinsic value and the margin of safety hands you the key to becoming a "smart investor."