Saturday, March 13, 2010

Is Intrinsic Value the Most Important Thing in Investing?

Many people may be familiar with investing in common stocks as growth vehicles in their financial portfolio. With information a click away on the internet and various books just as available on investing, it seems that everyone has the power to manage their own portfolio like they were a professional investment manager.

Many of these sources point toward Warren Buffet's style of investing, commonly known as value investing. The premise behind the strategy cites that investors own a small piece of a company. The basic philosophy is that a good investment is made in good companies selling at a discount to their intrinsic value.

However, caution and an analytical approach should be taken when defining intrinsic value, which is loosely defined as the price at which a person would be willing to pay for the whole business. This assumption is vague and not useful in practicum at all.

The truth about intrinsic value is that it is subject to the participants involved, meaning that, depending on the buyers and sellers own reasoning, intrinsic value will differ. If you were a small bank up for sale, you would most likely charge a far lower price to a private buyer than you would, say to Bank of America. This is mostly because variables such as the size of the buyer and synergy value come into play.

Furthermore, intrinsic value differs between how the buyer or the seller are evaluating it. While things such as future earnings are factored into both perspective values, there are variables that will discount the value of the business on the side of the buyer that would not affect the value to the seller. These are things such as lack of liquidity and non-diversifiable risk.

Likewise, the value of the business to the seller will factor in the size of the buyer that would not affect the value calculation on the part of the buyer. As a buyer, how big the company is should not make me change my estimate of what another prospective company is worth to me, but it will to the seller.