Welcome to our Value Investing 101 series. In Part 1, I explain what the “intrinsic value” of a stock is. Be sure to also check out Part 2 and Part 3.

## What is Intrinsic Value?

If you’ve read any of the articles on this website – or if you’re familiar with value investing concepts – then you may know that an Intelligent Investor will only buy a stock when its market value (that is, its stock price) is less than its intrinsic value.

In other words, a smart investment is one where you are buying a stock for less than its intrinsic value.

But what exactly is intrinsic value and how do you calculate it?

In the Berkshire Hathaway Owner’s Manual, Warren Buffett writes this about intrinsic value:

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

## Viewing a Business as a Bond

What does Buffett mean by this? Imagine a bond, for instance, which pays the bondholder interest every year and principal back at maturity. From Value Investing 101: The Time Value of Money, we know that a dollar today is worth more than a dollar tomorrow, and vice versa that a dollar tomorrow is worth less than a dollar today. Therefore, the interest and principal payments we receive in the future must be discounted to a lower value in order to determine their value today.

So, the present value of a bond = the discounted value of the bond’s future interest and principal payments. Now picture a company.

What is the purpose of a company? Answer: To generate dividends for the company’s shareholders.

This is a lot like a bond isn’t it? Except instead of being paid interest every quarter, a shareholder is paid dividends every quarter. This means you can discount the value of future dividends just the same way that you can calculate a bond’s future interest and principal payments.

Remember that the present value of a future payment = the future value of the payments, discounted at a certain rate?

In math form, this equation is the following (where i = the discount rate):

If the future payments will growth at a constant rate, then the equation can be simplified as:

The above equation is called the Dividend Discount Model (or the Gordon Growth Model) and its output is the intrinsic value of a stock.

## Example

Let’s try the DDM model just for fun. Let’s say a company is producing a dividend of \$1.00 per share and plans to grow that dividend by 5% per year for the next 20 years. Let’s also assume that you want no less than a 15% return per year on your investment. Here is the calculation:

As the years go on, the margin between the DPS and discounted dividends grows significantly. According to our calculations, in order to achieve a 15% return, we would have to purchase the stock at \$8.80 per share.

## Limitations of the Dividend Discount Model

You might argue, “but not all stocks pay dividends, and even the ones that do pay dividends don’t have a consistent dividend growth rate.”

You’re right, of course. Unlike with a bond, a company doesn’t have any contractual obligations to pay a dividend to its shareholders.

Furthermore, dividends alone don’t capture all of a company’s earnings. Besides paying a dividend, a business can also use the cash it generates to acquire new equipment or machines, to improve its factories or buildings, for research & development, to acquire another company, or to make other investments.

Any of these can be a better allocation of capital than if the company had paid a dividend. So while the dividend growth model (DDM) provides a good framework to understand intrinsic value, it doesn’t actually generate a realistic result.

## Next Up: DCF and Owner Earnings

In Part 2, we’ll take the DDM one step further and will use a Discounted Cash Flow analysis to calculate a more accurate intrinsic value of a stock.