The Importance of Intrinsic Value

The Importance of Intrinsic Value

The Importance of Intrinsic Value

Recently a colleague of mine with a question about investing approached me. More specifically, it was a question around investing in fine art (i.e. paintings). How do I know if I should be purchasing a particular piece? How I do I know if it is going to appreciate or depreciate? How do I know if I’m paying the right price for it? How do I know it’s genuine?

Upon hearing these questions I felt as though my brain was going to explode. I said to my colleague “colleague, we need to have a chat about intrinsic value.”

Intrinsic value is one of the most important cornerstones around value investing theory. As value investors, we seek to find the true, embedded value of an asset that we’d like to invest in. We hope that the asset is currently trading at a price that values the company below intrinsic value so that the market will realize this through “market value” and move towards this value, making us a profit. But what makes up intrinsic value?

Intrinsic value is the perceived value of a firm’s future cash flow, expected growth, and risk. This could be something as simple as the expected value of the business a company is going to bring in, the free-and-clear sales that are committed to from various contracts, or even the cash they will have in their accounts from windfall income or otherwise. But it can also be something more complicated to understand, like the sale value of their real estate – we must however be conscious of the fact that they would be required to sell this real estate in order for the cash to be realized. If they don’t sell, well then, there is no cash flow value coming from that component.

In addition to intrinsic value and market value, there is also book value to be considered. Book value is an accountant’s estimation of what the company is worth. Accountants make these estimations on assets and liabilities and take these as the true values without too much consideration for intangibles – this can be a whole different discussion.

Calculating intrinsic value can also get quite difficult and, in some circles, is considered more of an art than a science. The intrinsic value of a bond is much easier to calculate than that of equity because, often, the cash flow is consistent and predetermined, the timeframe is fixed, and an analyst must only determine a suitable discount rate. Equity valuation involves uncertainty in application of cash flow, which affects risk, and a whole mess of other factors.

One thing is consistent amongst everything that I just mentioned: intrinsic value places a lot of weight on cash flow.

So what is the intrinsic value of fine art? There isn’t any. Fine art has no cash flow and doesn’t have any intrinsic value higher than the canvas and paint used to create it. The value that art investors place on a piece is solely derived by the expectation that someone else will pay an inflated value for it when they choose to buy it. Without an intrinsic value, it can’t be purchased at a discount with the hopes that a moving market value brings about a profit. It isn’t a value investment.

So, “colleague, you shouldn’t be purchasing a piece of fine art if you call yourself a value investor, you have no idea if it will appreciate or depreciate, you likely aren’t paying a fair price for it, and who cares if it’s genuine because there are enough reasons to qualify it as a bad and risky investment.”