Investment guru’s often refer to the term “intrinsic value” when discussing how to value a share. Many neophyte investors do not understand the meaning of this term let alone how to calculate it. Warren Buffet once said “intrinsic value is impossible to pinpoint but essential to estimate”.

Intrinsic value is basically the value that an informed investor would pay for a business. As this value depends on what happens to the business in the future, it is, at most, an educated guess.

One can use complicated methods such as discounted cash flows, or less complicated methods such as guestimating the correct Price Earnings ratio for a share, based on earnings growth as well as the future growth expectations. Unfortunately, no two analysts' calculations will produce exactly the same value.

This is why it is so important to add a margin of safety. If you believe that the share should be trading on a PE of 10, don’t buy it on a PE of eight; rather buy it on a PE of five. This leaves room for error if the future shows that you were too optimistic about the company’s prospects.

It is of the utmost importance to all investors that they make a guestimate of the intrinsic value of a share. Good books to read on rule-of-thumb valuations are the "Zulu Principal" or "Beyond the Zulu Principal" by Jim Slater.

There is also a website dedicated to this type of analysis called www.Intrinsicvalue.com. Some of the information may seem a bit "technical", but if you want to get into the “nitty gritty”, it contains all the necessary information.

By Diedrich Schutte PSG Online, published in SA Smart Investor magazine

RSS
Digg
de.li.cious
facebook