Fundamental (intrinsic) value is the cash generated by an investment. Fundamental value is earned in the future as dividends, interest, and principal are paid or as retained earnings are successfully reinvested. Risk is the likelihood and potential magnitude of a decline in investment cash flows, or the payment of a market price at purchase which is higher than fundamental value.
When buying, we never confuse fundamental value with market price. Market price is what we pay. Fundamental value is what we get. Market price may be found quoted daily in the financial press. Fundamental value is determined by investment cash flows.
Market price, it follows, is not a barometer we would use to evaluate corporate performance. Our evaluation of corporate performance is based on items such as income, assets, and return on capital. We view the stock price of a publicly traded company simply as a record of what others – well informed or not – were willing to pay for it at various times in the past.
Fundamental value is such a critical concept because it is the only reference point for what an investment is actually worth, and therefore, whether or not the market price is fair, high, or low. Two facts support this view. First, the theoretical point that an investment is worth the present value of its future cash flows is self-evident and undisputed. Second, new era theories that have driven prices to speculative levels in the short run have always succumbed to the basic idea of fundamental value in the long run.