Island Investing: More on Intrinsic Value

From today’s KeysWeekly, more nuggets of investing goodness, 350 words at a time:

Q. Can you explain the concept of “intrinsic value”?

A. Would you rather receive $100 today, or $100 a year from now?

Most people would take the money today. After all, if you took the $100 in cash now, invested it in a bond yielding 5%, in a year you’d have $105. And why opt for $100 in a year when you could instead have $105 by then?

One of the core principles of investing is that a dollar received today is worth more than a dollar received in the future. The owner of that dollar must be compensated for the opportunity cost of tying that money up.

Imagine a machine that spits out a single new dollar bill once a year, every year, for ten years. What would you pay to buy it? If you said an amount higher than $10, put down the margaritas. Paying $9 might seem smarter because you’ll lock in a $1 profit – but there are higher returns you can earn elsewhere on that $9. If you invest $9 for ten years and it turns into $10, you’ve earned a total return of 11.1% – only about 1% a year. You could do better with a savings account at the local bank.

If you knew the long-term average annual return of the U.S. stock market was 11% a year, however, you can justify paying only $3.52 for the machine. Why so little? Because $3.52 invested for ten years earning 11% each year magically becomes $10. The dollar machine has got to at least match that 11% annual return, or else you’ll just put your money in the market to grow it faster.

That is the essence of successful investing – finding good companies that are dollar machines in the most literal sense. The price that you would pay to buy the dollar machine today is its “intrinsic value.” Companies also have intrinsic values, based primarily on their profits. The basic concept is the same. Though valuing companies can be a bit more difficult, there are also some shortcuts I’ll discuss more next week.

Note: One thing I probably should have reiterated in the print version of the column above is that determining intrinsic value is both an art and a science. It’s also highly subjective. You may pay more or less than $3.52 for the dollar machine depending on the other investment opportunities available to you. The 11% rate used in that example is also called your “discount rate”, which is the lowest return you’d be willing to accept given other opportunities you have that may earn more. So if buying investment properties is more your thing, and you can earn 8% a year in doing so, then the price you’d pay for our dollar machine above would increase a bit.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
This entry was posted in Island Investing. Bookmark the permalink.