Tell intrinsic value apart from market value
The idea
Market value is the price at which a security currently trades; intrinsic value is what it is worth given a complete understanding of its characteristics. In a perfectly efficient market the two are always equal and active management cannot add value. In practice they can differ, and the active manager's claim is precisely that they can identify the difference. The difficulty is that intrinsic value is unobservable and every estimate of it is itself uncertain, so an apparent divergence is at least as likely to indicate an error in the analyst's model as a mispricing in the market.
A practice question
What is market value?
- The price at which the security currently trades - correct
- The book value of the underlying companyWhy not: An accounting figure from the balance sheet, which can sit far from any traded price.
- The analyst's estimate of worthWhy not: That is the estimate of intrinsic value, the thing market value is compared with.
Market value is the price at which a security trades right now, so anyone can see it. For example, if a share last traded at $45, its market value is $45, whatever an analyst thinks it is worth. Intrinsic value is the value based on a full understanding of the company. It cannot be observed directly and has to be estimated. Book value is an accounting figure, Assets - Liabilities, which can sit far from the traded price.
A harder one
Why is intrinsic value described as unobservable?
- Because companies do not publish itWhy not: Nobody could publish it; it is not a fact the issuer holds back but an estimate that depends on knowledge no one has in full.
- Because it changes dailyWhy not: It does change as circumstances change, but a quantity can move and still be observable - the market price does both.
- Because nobody has complete information - correct
Intrinsic value means what a share is worth if you knew everything about the company and its future. Nobody knows everything, so intrinsic value can only be estimated, never seen. Two analysts may look at the same share and reach $55 and $62 using different growth guesses, and neither can prove the other wrong. A market price is different, because you can see it in actual trades, even though it changes often. Companies are not hiding the number. The figure is unknown to everyone because it depends on information no one has in full.
The hardest tier
An analyst's model values a widely followed stock at half its market price. What is the most likely explanation?
- The market has systematically mispriced a well-covered securityWhy not: Possible, but it is the least likely explanation for a stock that many capable analysts follow, so it should be checked last.
- An error or an unrealistic assumption in the analyst's own model - correct
- Trading in the stock has been suspendedWhy not: A suspension would stop the price updating, not make a model disagree with it by half.
A share followed by many skilled analysts is rarely wrong in price by as much as 50%. So when your model says the value is half the price, the most likely cause is a mistake in your own model. For example, a discount rate set too high or a growth rate set too low can easily make a value far too small. Check the assumptions before acting. A trading suspension would freeze the price, not create a gap between price and a model.
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