Do you use fair value or intrinsic value?

The two expressions intrinsic value and fair value are used interchangeably by most investors, certainly including myself so far! I believe we should use the two expressions more deliberately going forward and focus on the small differences. Here is why …

Intrinsic or fair value is one of the most important elements to internalize for value investors and their investment process. Without estimating fair value and buying securities only below that estimate, I would not call an investing approach value investing. Performing an estimation of value is the necessary condition to call your approach value investing …

However, there might be a few situations where prior to buying into a security it is enough to conclude, that fair value is significantly above current prices. I felt this way when I bought into Progressive. In Howard Marks’ words:

»You can’t have intelligent investing in the absence of quantification of value and insistence on an attractive purchase price.« – Howard Marks, in Mastering the market cycle

There are two possible perspectives that I can think of when using the two expressions intrinsic value and fair value. Investors mostly use them interchangeably. So far, that certainly included myself! I believe, we should use them more deliberately going forward and focus on the small differences.

If you can’t ever sell an asset your valuation perspective is different when compared to liquid investment opportunities. Just imagine you are evaluating a real estate investment opportunity. Adopting this view might be useful even when dealing with stocks that we can sell on a daily basis. When taking this view it becomes clear that we can expect the company’s or asset’s intrinsic return (there is no price or multiple expansion anymore). If we buy into an asset at its intrinsic value, we can expect fair or intrinsic returns on our investment (aligned to cost of capital used in our DCF valuation). If we buy at a discount to or below its intrinsic value, our returns will be slightly higher, but will converge over time. Taking this intrinsic value -perspective, it becomes clear it is not enough to choose fair costs of capital. It is also about the questions for what minimum return we are willing to settle?

»The intrinsic value of a security is the maximum price that an investor would be willing to pay to own the security if she could not ever sell it.« – Philosophical Economics

from intrinsicinvesting

You could also trust the market or market participants to price an asset fairly in the future with regard to risk and returns. Taking this view, you would expect an asset to trade for its fair value in x years. It could also happen earlier, later, or never. We just don’t know. Sometimes, Catalysts might be needed for the market, or more precisely its participants, to wake up and to fairly price the asset. In addition to fair returns over the x years (until fair repricing), you can realize returns that are higher than the intrinsic returns if you invested at a discount to its fair value.

What is fair can be up to discussion, especially so when its about valuation parameters. Merely asking this questions highlights an under-appreciated difference between the two terms. If you believe a low discount rate is fair (probabaly because an investment is perceived as low risk) but the market does not agree, the desired repricing might never occur and thus your fair value estimate might not be worth much. Adopting the intrinsic value -view, you might come to a different conclusion by asking yourself:

Am I willing to hold this asset forever,
earning the company’s intrinsic return ?


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