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 intrinsic value?
- The price at which a security last tradedWhy not: That is market value, and it is observable. Intrinsic value is the estimate the price is being compared against.
- The book value of the issuer's equityWhy not: Book value is an accounting residual of past transactions. Intrinsic value looks forward to what the security will produce.
- The value given complete understanding — correct
It is what a security is worth to someone who understood all of its characteristics: the analyst's estimate of true worth, which may differ from the observed price. Only in a perfectly efficient market are the two identical at all times.
A harder one
What is the active manager's implicit claim about these two values?
- That market value can differ from intrinsic — correct
- That market value is always wrongWhy not: Far stronger than active management needs or claims. It is enough that the two diverge sometimes and that the divergence can be found.
- That intrinsic value is directly observableWhy not: If it were observable there would be no analysis to pay for. The claim is about estimating it better than the price does.
The claim is not only that the gap exists but that they can find it. Active management is only worth its fee if both are true, and neither can be assumed.
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 many capable analysts follow, and it is the one that should be tested 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.
Many capable analysts follow such a stock. A divergence of that magnitude is far more often traced to a growth or margin assumption than to a market-wide failure, and the model should be examined before the position is taken.
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