The terms intrinsic value or fair value are often used by value investors. Their meaning is one of the most important elements to understand and to internalize within our value investment process. Without estimating fair value and buying securities only below that estimate, I would not call an investing approach value investing – I might not even call it investing at all. 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 I can generally think of: The two expressions intrinsic value and fair value are mostly used interchangeably by investors and certainly included myself! But maybe I should use them more deliberately going forward and focus on small differences. Here is why.
You could 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 eventually or in x years. It could also happen earlier, later, or not at all. 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 holding period (until fair repricing), we can realize additional returns if we invested at a discount to its fair value.
What is fair can be up to discussion. Merely asking this questions highlights an under-appreciated difference between this 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, a 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 its intrinsic return at current prices?
If you can’t ever sell an asset your valuation perspective is different when compared to liquid 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 intrinsic returns (there is no price or multiple expansion anymore). If we buy into an asset at its intrinsiv value, we can expect fair returns on our investment (cost of capital) over the long-term. If we buy at a discount or below its intrinsic value, our returns are slightly higher, but will converge over time. Taking this 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 want 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 Economicsfrom intrinsicinvesting
- Do you use fair value or intrinsic value? (Dec 2020)