Intrinsic value vs market price

A stock's market price is a fact you can look up at any moment. Its intrinsic value is a judgment about what the business is really worth, based on the cash it can generate for its owners. The difference between the two is the starting point of value investing, but it is also easy to misuse, because only one side of the comparison is observable.

Two different things

Market price is the most recent price at which a willing buyer and a willing seller agreed to trade. It reflects everything investors collectively believe, feel and are able to do at that moment, including expectations, fear, fashion and the constraints of funds that must buy or sell.

Intrinsic value is an estimate of the present value of the cash a business will distribute to its owners over its remaining life. It depends on assumptions about growth, profitability, reinvestment and risk. Two careful analysts can estimate different values for the same company, and neither can be proven right in advance.

Intrinsic value = present value of expected future cash flows to owners

The usual tool for this is a discounted cash flow model, supported by comparisons with similar companies.

Graham's Mr. Market

Benjamin Graham offered a famous image in The Intelligent Investor. Imagine a business partner, Mr. Market, who shows up every day and offers to buy your share or sell you his at a specific price. Some days he is cheerful and quotes a very high price. On others he is gloomy and quotes a very low one. You do not have to trade with him. The lesson is that the price is an offer, not a verdict. It can be useful when it is far from your estimate of value, and it can be ignored the rest of the time.

Example (illustrative numbers)

Three careful valuation approaches give estimates of $80, $100 and $120 per share, so the working range is $80 to $120. How does the market price compare?

Note that a price inside the range is not "exactly right", and a price outside it is not "certainly wrong". It means the market and the model disagree about something. Finding out what is the real work.

Why price and value differ

• Different expectations. The market may expect faster growth or higher margins than your model, or the reverse. A reverse DCF works backward from the price to reveal the expectations it contains.
• Different discount rates. A change in interest rates or in the compensation investors demand for risk changes values for everyone.
• Information and interpretation. New information arrives continuously and is interpreted differently by different people.
• Sentiment and flows. Fear, enthusiasm and forced selling move prices in ways that are unrelated to business cash flows, at least for a time.
• Model error. Your estimate may simply be wrong. This is the most common reason of all, and the main reason to be humble about gaps.

What the gap can and cannot tell you

It can flag where the market's implied expectations look unusually pessimistic or optimistic compared with a reasoned estimate, and it can help structure questions: what would have to be true for this price to be fair?

It cannot:

• Say when the gap will close, or whether it will. Prices can stay far from estimated value for long periods.
• Prove that the market is wrong. Markets aggregate a great deal of information, and a price well below your estimate may reflect something you have missed.
• Make a poor business good. A cheap price on a deteriorating company is a value trap, not an opportunity.

Treat value as a range

Because estimates are uncertain, the honest output of a valuation is a range with a most-likely region, not a single figure. Methods also disagree: peer multiples, DCF and earnings power can each point to different values. Their disagreement is information about uncertainty. See fair value is a range and relative valuation with peer multiples.

Requiring a cushion before acting on a gap is the idea behind the margin of safety.

Rules of thumb

• Estimate value before looking at the price, if you can, to avoid anchoring.
• Use at least two methods and compare them.
• Ask what the price implies, not only what you think.
• Revisit estimates when new information arrives; value is not fixed.
• Remember the market is not obliged to agree with you on any timetable.

Where to see it on StocksXray

StocksXray compares a fair value range with the current price and labels stocks Undervalued, Fair or Overvalued using a margin of 20%, 30% or 40% according to model uncertainty. Browse the undervalued, fair and overvalued lists, and see the methodology page. The labels describe the gap between price and model, not a prediction.

Key takeaways

• Market price is observed; intrinsic value is estimated from expected cash flows.
• The two differ because of different expectations, discount rates, sentiment and model error.
• The gap is a prompt for questions, not a timing signal or proof of mispricing.
• Think in ranges, use several methods and require a margin of safety.