Intrinsic Value: What Doesn't Count? Some Interesting Phenomena.

Intuitively, the concept behind intrinsic value is well understood. However, I repeatedly observe various unrelated factors get into its definition. This post will highlight two of those.

The intrinsic value of the business is primarily based on its 

• Asset value, 
• Earning power value, 
• Growth prospects,
• Interest rate, 
• Management and Capital allocation, 
• Competitive position, and 
• Capital structure. 

There could be other factors specific to the company or industry. While an intrinsic value calculation is not simple, it is an estimate that changes based on various factors such as business conditions, future prospects, management, and interest rates. Thus, various qualitative and quantitative factors determine the intrinsic value of the business.

If we look at the current practice to discern what constitutes intrinsic value, I find two factors impacting the business valuations (subsequently investment decisions) by market participants. 

Photo by Jakub Żerdzicki on Unsplash

Popularity

Popular companies often attract investors who base their decisions on recent favorable earnings, news about flashy new products, endorsements from charismatic company officers or recommendations from from friends or neighbors. As this behavior percolates among market participants, it creates its own momentum, leading to elevated stock valuations. 

A typical sequel to such situations leads to a decline in such enterprises' market values. Such declines can sometimes present interesting investing opportunities, particularly in larger companies, as Mr. Ben Graham noted in his book The Intelligent Investor. The fundamental reasons are that these companies possess sufficient resources and the market can easily become enthused about such stocks again. 

Market Activity

In the short term, the price of the stock is impacted by market participants looking to make quick profits, resulting in higher trading volume. This factor leads some investors to mistakenly believe that such a security should also garner a higher relative valuation compared to stock with lower trading volume.

A consequence of lower market activity sometimes leads to an interesting phenomenon. A voting stock, held by a few shareholders, may sell below the non-voting stock. Logically, one would expect a common stock with voting privileges and a limited shareholder base to sell at a higher valuation than its peer common stock with no voting power. Yet, speculators are willing to pay higher prices for the non-voting stock because it can be traded easily. These situations sometimes could be the source of investment opportunity.

A similar anomaly sometimes arises in participating preferred stocks. Such preferred could sell well below the common stock despite having a senior position and similar rights to the company's income. 

As an investor, the aforementioned two factors can be important for reasons other than intrinsic business value, such as the size of the investor's portfolio. Building a substantial position in a stock with a lower daily trading volume can be challenging.

There are already inherent risks specific to a business. Introducing the preceding two factors in the investment decision-making process can greatly increase the danger of paying high prices by intrinsic value standards.

Abhay Srivastava is the Founder and Managing Member of AS Investment Partners LLC, a value investing firm.

Abhay can be reached at abhay@asinvpartners.com

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