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What is the Difference Between Intrinsic Value and Book Value?

Intrinsic value and book value are two commonly used methods to calculate the value of a company. Although both attempt to do the exact same thing, the methods of calculation differ.

Book value makes use of items on the balance sheet to calculate a company’s value whereas intrinsic value takes into account the earnings potential of a company.

With that, let’s take a look at how to calculate each of them.

Book value

Book value is the simpler of the two. It is a measure of the value of all the company’s assets minus its liabilities. In theory, this is the amount shareholders would receive if the company were to be liquidated.

To calculate book value, we simply deduct the company’s liabilities from its total assets. For example, a company with $10 billion in assets and $2 billion in liabilities would have a book value of $8 billion.

However, it is important to note that not all the assets listed on the company’s financial reports can be meaningfully sold. Some of the intangibles like goodwill, patents, and intellectual property have a value of the balance sheet but cannot be sold on the open market. This can result in a discrepancy between book value and the actual liquidation value of the company.

Investors often compare book value with the market capitalisation of the company. This gives them an idea of whether they are paying more or less than the liquidation value of the company. Book value is especially useful in calculating asset-rich companies or companies like real estate investment trusts and investment holding companies.

Intrinsic value

The intrinsic value of a company is a calculation of the value of a company based on all aspects of the business, including intangible assets and its earnings potential. It can be calculated using the discounted cash flow model, which looks at the future cash flows of the company to estimate the current worth of a company. An analysis of this calculation technique can be found in an earlier article.

This method of calculating a company’s value is also Warren Buffett’s preferred method as he believes a company should be valued based on how much cash it can generate.

Having said that, the discounted cash flow model requires forecasting of the company’s future cash flow. Different investors or analysts may have different forecasts and consequently, arise at different intrinsic values of the company.

Furthermore, we need to estimate the discount rate of the cash that is generated (cash on hand is more valuable than future cash flow). Different discount rates will also lead to a different intrinsic values. A prudent investor would, therefore, try to be as conservative as possible. A company that trades below a conservative estimate of its intrinsic value should be considered a much safer investment.

The Foolish takeaway

As investors, these two methods of calculating the value of a company can go a long way in helping us spot bargains in the stock market. Both of them have their advantages and can be used in the calculations of specific stocks.

It is important, however, not to use these calculations in isolation to invest in a company. There are other factors to consider before putting our hard-earned money into a stock.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.