Intrinsic Value Determines Potential Success

Investors who guess at a stock’s fair market value will soon find themselves wondering where all their money went, because they will not know if they are paying too much for the stock. Smart investors buy a business, not a stock. They analyze the business using proven formulas and arrive at a price for the stock that reflects the value to investors. That price is the stock’s intrinsic value, which considers all of the company’s assets, both tangible and intangible. When you know the intrinsic value of a company, you can decide whether the stock is overpriced, underpriced, or priced about where it should be. All investors should avoid overpaying for a stock. If this seems like obvious common sense, you are right, but it is not an approach all investors follow.

Some investors tell themselves all sorts of stories to justify paying more for a stock than its intrinsic value. However, smart investors are patient and wait for a stock that can be bought at a price that gives them a reasonable chance of making a profit. That patience is one of the distinguishing features of a long-term investor. Buying great companies at a great price is the recipe for success.

The process of determining the intrinsic value of a stock involves two broad steps. There is no particular order to the steps. If you encounter major problems with either step, you may want to skip straight to another investment candidate. The two steps are shown here:

1. Determine a price for the stock that reflects its value to investors.

2. Determine if the company has a sustainable economic advantage or moat.

Of the two, analyzing the company’s economic moat is a bit more subjective. However, if the company has no economic moat or one that appears unsustainable, I would suggest you pass on that stock and move on to another.

DEFINITION