Intrinsic Value: Understanding True Worth

Without a grasp of intrinsic value, it's not investing — it's speculation.

The concept of intrinsic value may sound technical, but it originates from just two simple foundational truths in finance:

1. Time has value – A dollar today is worth more than a dollar tomorrow. This is the principle of the "time value of money": money can grow over time when invested, so future dollars are discounted to reflect their present worth.

2. Certainty has value – We prefer certainty over uncertainty. And when uncertainty is unavoidable, we expect compensation for bearing that risk. In other words, riskier investments must offer higher potential returns to be considered worthwhile.

These two ideas—time value and risk compensation—are the bedrock of valuation. Whether you're analyzing a business, a bond, or a stock, intrinsic value is about estimating the future cash flows you expect to receive, and then adjusting them to reflect both timing and uncertainty.

This article walks you through a simple but powerful framework for understanding intrinsic value, using practical concepts and relatable examples. These fundamentals help long-term investors make better decisions.

Present Value vs. Future Value

At its core, investing is about trading money today for more money tomorrow. If you invest $100 now and expect a 10% return, you'll have $110 next year. But if you're promised $110 next year and want to earn 10%, you'd only be willing to pay $100 today. This is the principle of present value. The expected return is called the discount rate, and it helps translate future money into today’s dollars.

Discounting a Series of Cash Flows

Most investments—especially businesses—generate not just one future cash flow, but a stream of them. To find the present value, we discount each future cash flow back to today. For example:

• Year 1 cash flow is discounted by 1 / (1 + r)

• Year 2 by 1 / (1 + r)²

• And so on…

Mathematically, this can be written as:

Sum of all discounted cash flows in the future, where:

• Cn is the expected cash flow in year n

• r is the "discount rate", or "expected rate of return"

When cash flows are expected to be constant fora relatively long period of time, this formula is equivalent to:

This simple relationship is a powerful mental model: the more stable and predictable the cash flows, the more meaningful this simplification becomes.

Linking It to the P/E Ratio of a Stock

Price of a stock represents the "Market Value" of a business which does not necessarily link to "Intrinsic Value".

Company's earning per share is a simplistic approximation of its cash flow.

If the "market Value" follows the "Intrinsic Value", and earning is approximately equal to "Free Cash Flow", the following formula is correct and very useful:

For example, if you are expecting 10% return, you should not pay more than 10 times the earning for the stock (1 divided by 10%).

So a stock with a P/E of 10 implies an expected return of about 10%. A P/E of 20 implies about 5% expected return. It’s a quick and intuitive way to anchor your valuation expectations—especially useful when comparing companies in similar industries or evaluating broad market levels.

Does Market follow Value?

Yes, in the long run!

No, in the short run!

Retail investors, and even institutional investors may ignore the reality of business performance, and have exaggerated assumptions and cognitive biases.

A series of uninterrupted market rises causes undisciplined actions, backed by media noises, partial information, and overoptimism.

Without a grasp of intrinsic value, it's not investing — it's speculation.

Investing vs. Speculation

While as a rule of thumb, one is better to be invested always, they should understand the fundamentals, stay disciplined and select investments thoroughly.

Of course, reality is rarely this clean. Cash flows can vary, risk changes over time, and companies reinvest earnings at different levels of effectiveness. That’s why intrinsic value analysis should neither be treated as an exact science nor the only analysis tool.

Still, the core idea always remains true: every investment is a trade-off between price and expected return.

Some extra topics:

Adjusting for Growth

If a business is growing, future cash flows will increase—which makes the business more valuable today. That’s why growth is a critical component of valuation. Models often account for it explicitly using a growth-adjusted formula or a terminal value to estimate value beyond a forecast period.

Treatment of Inflation

Inflation also plays a role. Some models forecast in “nominal” dollars and adjust the discount rate accordingly. Others work in “real” dollars, excluding inflation from both cash flows and discount rates. Either way, what matters is consistency and clarity. One has to reflect the same real or nominal assumption for both cash flow prediction and using an appropriate discount rate, and across all comparisons.

Net Earning is not a true reflection of Free Cash Flow

Technically, free cash flow should always be used rather than accounting earnings. In practice, estimating free cash flow requires reconstructing it from income statements, cash flow statements, footnotes, industry growth, level of competition, management, and many other factors and assumptions.

As a quick and dirty analysis, one can use net earnings as a stand-in for cash flow - but it's important to be cautious. Net income reflects accounting decisions, not actual cash movements. It makes assumptions about depreciation, accruals, and capital allocation, which may not hold up under closer scrutiny.

Know the limitations of models and formulas

Of course, reality is rarely this clean. Cash flows can vary, risk changes over time, and companies reinvest earnings at different levels of effectiveness. That’s why intrinsic value analysis should neither be treated as an exact science nor the only analysis tool.

Still, the core idea always remains true: every investment is a trade-off between price and expected return.

Conclusion

At its heart, intrinsic value is a logical framework for thinking clearly about investments. It’s not about guessing what the market will do next - it’s about understanding what something is worth based on its ability to generate future cash flows.

Whether you're using a detailed discounted cash flow model or a rough P/E shortcut, the core question remains the same:

What return am I getting for the price I’m paying?

Mastering this mindset - grounded in time, risk, and reward - is one of the most powerful habits any long-term investor can build.