What is Intrinsic Stock Value?

Intrinsic stock value is a concept that emerged from the carnage of the 1929 to 1932 stock market crash. It is a way to invest rationally as opposed to investing by guess work, which is closer to gambling. To get a sense of the way this concept changed the face of investing we need to go back to an era where investing in the stock market really did resemble gambling at the casino.

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“Playing the Market” in the 1920s

All of that lasted until 1929 when the stock market crash started from Black Thursday (October 24) to Black Tuesday (October 28). The Dow Jones Industrial Average began the 1920’s at 100 and peaked in 1929 at 381.17. It then lost nearly half its value down to 198.69 in the 1929 crash. ( Dow Jones history 1920–1929) Then, despite a brief recovery, the market and the Dow continued to slide until the Dow reached 41.22 in July of 1932. ( Wikipedia Wall Street Crash of 1929) A huge number of wealthy investors were wiped out during this period but some regrouped, learned from their mistakes, and moved on to create safer and more profitable ways to invest. One who stands out from this era is Benjamin Graham.

Dow Jones Industrial Average: 1920s
Dow Jones Industrial Average: 1920s

Benjamin Graham, Intrinsic Stock Value and Value Investing

Benjamin Graham, Father of Intrinsic Stock Value
Benjamin Graham, Father of Intrinsic Stock Value

Intrinsic Stock Value

Mean Reversion

Efficient Markets

Margin of Safety

Determining Intrinsic Stock Value

The problem in applying an intrinsic value calculation to a stock is that all too often the medium and long-term prospects of a company and its earnings are not clear. None other than a student of Graham and one of the most successful investors ever, Warren Buffett, has said that he throws out the vast majority of possible investments as too difficult to call! To make the intrinsic stock value concept work in the real world investors need to have a clear idea of how a company makes its money and how that business plan will continue to work. In doing this the investor looks at how a company manages its assets, the viability of its products and services, its R&D, marketing, and competitors.

Intrinsic Stock Value Formula

V = EPS x (8.5 + 2g)

V is the intrinsic stock value
EPS is the trailing 12 months earnings per share
8.5 was the P/E ratio at the time for a “zero-growth” stock
g is the company’s long term rate of growth

Here is the 1974 revision.

V = EPS x (8.5 + 2g) x 4.4 / Y

In 1962 the average yield of high grade (risk free) corporate bonds was 4.4%. Y was to be the current yield of AAA corporate bonds.

( Investopedia Benjamin Graham)

It is noteworthy that Graham added the interest rates of bonds to his calculation as government spending for new social programs as well as the Vietnam War (Guns and Butter) drove interest rates sky high and ushered in a period of “stagflation.”

Applying Intrinsic Value to Investing

The “V” for intrinsic stock value is used to find the Relative Graham Value or RGV. Simply divide the intrinsic value of a stock by its current market price. This is the RGV. An RGV of less than one means that the stock is currently overpriced and should be avoided or should be sold if it is in the investor’s portfolio. An RGV of greater than one is indicative of an undervalued stock for which the market has not yet caught on. This is a stock to buy and hold at least until the mean reversion occurs and the market price catches up with the intrinsic value of the stock.

Intrinsic Value Is Not Just a Buy and Hold Investing Tool

Does Intrinsic Stock Value Work for Every Stock?

Berkshire Hathaway, an Example of Intrinsic Value Investing
Berkshire Hathaway, an Example of Intrinsic Value Investing

Intrinsic stock value is a valuable tool for smart investors. Using it requires work and attention to detail. And, by using it, investors typically make more money and sleep better too!

Does Intrinsic Stock Value Work for Every Stock?
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