December 8, 2014

Intrinsic vs Extrinsic Value

A recurring theme in our finance class this period is that of intrinsic vs extrinsic value. Intrinsic value is the value of the company from the eyes of insiders and includes the value of assets while extrinsic value is the value of the company from the point of view of outsiders and includes public perception.

It is particularly interesting concept, especially in the context of business valuation and the stock market. A lot of times, when valuing a business there are two schools of thought: using projections of future cash flows and using multiples. The first takes an intrinsic valuation approach while the second takes a extrinsic valuation approach.

The problem with the first method is that most casual observers do not have the capability or the resources to do it properly. The problem with the second method is that the stock market is volatile and extrinsic value as dictated by the market rarely matches a company's intrinsic value.

So where does this put us casual investors? I am not an expert, but in theory, it should be possible to use both methods hand in hand. Here are a few tips:
  1. Before investing in a company, review the basics financial statements like their balance sheet and income statement. Having a strong balance sheet and income statement is a good signal that the intrinsic value of the company is sound. What to look for? Aside from profit and income ratios, also take a look at the ratio of assets to liabilities.
  2. Study the market trends. Is the market on a bull or bear run? Companies tend to be overvalued during bull runs and bubbles (sometimes irrational) form during periods of positive outlooks. Tread carefully when the market is overly optimistic and be on the lookout for bargains during downturns.
  3. Don't try and predict the stock market (and don't believe those who say they can). Many have tried and failed. There are times when movement seems rational, like a stock price going down after a negative earnings report, but more often than not, unless you have a time machine, it is very difficult to accurately predict show the market will move. Have a buy-in and sell-out price in mind and stick to it.
By studying the trends (extrinsic) and making sure to do your homework (intrinsic), you can help yourself become a much more savvy casual investor. Rarely believe the hype as this is when bubbles form.

Below is a 52-week snapshot of the Philippines Stock Exchange Index. So, what do you think, is it real growth or just a bubble?