Intrinsic value of a stock is its real value. It is estimated by considering the future monetary benefit an investor can expect from it. Intrinsic value, in simple terms, is the maximum value that an investor can buy an asset at, without incurring a loss while selling it in the future.
Understanding intrinsic value with an example
For a stock price to rise or fall, it must first begin at some point. Suppose the price of a stock is currently Rs. 200. If an investor uses technical analysis, he/she arrives at a conclusion that the price may rise to Rs. 300. So, where did the current price of Rs. 200 arise from? To know this, we need to know about intrinsic value. In the below section, we will discuss the various methods to determine the intrinsic value of a stock.
Difference between market value and intrinsic value
A logical question that any investor would ask is whether intrinsic value is the same as market value? The answer is no. These two are different stock valuations that are often confused with another. The table below talks about the difference in brief:
|Parameter||Market value||Intrinsic value|
|Meaning||Current trading price that one pays for buying a stock on an exchange.||Estimated real value of the stock based on the company’s financials.|
|Example price of Stock A||Rs. 10Market value is lower than intrinsic value||Rs. 20Intrinsic value is higher than market value|
Since the above example states that the intrinsic value of the stock is higher than the current market value, the stock is said to be undervalued and may have a good safety margin. An investor must, therefore, aim to buy this stock.
How to determine the intrinsic value of stocks?
Intrinsic value of a stock can be calculated using below methods:
1. Relative valuation
One of the most preferred valuation methods to determine the intrinsic value of a stock is the Relative Valuation method.
- Determines a company’s intrinsic value using company fundamentals and current market value.
- Can be used to determine whether a company is under or overvalued as compared to its peers.
- Used by investors to estimate a company’s market value.
Various financial ratios can be used to know how the company is performing. By understanding the ratios, one can gauge the overall health of a company.
The three key ratios that are used to calculate a company’s intrinsic value are:
- Price-Book Value Ratio
- Price-Earnings Ratio
- Price-Sales Ratio
Alternatively, investors can also use the Enterprise Value (EV) ratios to estimate the intrinsic value. These are:
- EV-EBIDTA (earnings before interest depreciation tax and amortization)
- Price-Sales ratio.
2. Discounted Cashflow Method (DCF)
Under this method, Intrinsic Value is the estimated value of a stock determined as per its future cash flows. Since this value is determined as a function of market expectations, it is different from the market price.
This method takes the sum of a company’s forecasted future cash flows to estimate its value. To estimate a company’s value as per its ability to gain a cash position, the future cash flows are further discounted with a required rate of return.
The formula for calculating intrinsic value using discounted cash flows is:
CF1 / (1 + r) + CF2 / (1 + r)^2 + CF3 / (1 + r)^3 + and so on
CF1 = Cash flow in year 1
CF2 = Cash flow in year 2
And so on..
Let’s take an example.
A company’s financials are as below:
Average cash flow = 6% per annum
Required rate of return = 4%
Most recent cash flow = Rs. 80 lakhs
|Cash flow||Discounting||Discounted cash flow|
If the company is expected to be in business till the next 40 years, the total cash flow value at the end of 40 years will be around Rs. 4,844 lakhs.
Assuming that it will have 20 lakh shares outstanding, the intrinsic value of its stocks will be:
=4,844 / 20
= Rs. 242
Why should investors know the intrinsic value of a stock?
Intrinsic value may sound like a complex terminology, especially to new investors. However, it simply means “pure value”. When an investor estimates the intrinsic value of a stock, he/she is essentially trying to gauge the stock’s value if it is purchased and sold in the present. It is a helpful tool since it provides an immediate estimate of how much a stock is worth right now. An investor can then compare the intrinsic value of the stock to its current price and understand if it can be a good investment. It also helps an investor to gauge the profitability of potential investments by comparing intrinsic values of different stocks.
Drawbacks of intrinsic value
Here are some of the drawbacks of intrinsic value that investors should know before using it:
- One of the drawbacks of using intrinsic value computing methods is that it can be subjective. While using this technique to project cash flows of a company, an investor has to make many assumptions. Hence, the net present value can change drastically due to changes in the underlying assumptions.
- While estimating the weighted average cost of capital, the underlying factors, such as market risk premium, may be calculated differently. The probability aspect used in these calculations can also be subjective.
- As they say, the future is always uncertain. Thus, different investors may conclude differently as far as valuing the same asset is concerned. This is because each individual may have a different take on the future. Also, there is no one way to figure out the accurate number out of many calculations.
Intrinsic value is an important aspect in determining a stock’s value for investment purposes. Since there are many ways in which one can evaluate the true value of a stock, investors must try to use the best method depending on the company’s sector and after considering the unique characteristics of the company.
The dividend discount method (DDM) is one of the easiest ways to determine the intrinsic value of a stock. It is mainly used for evaluating stocks of larger and stable companies. This method focuses on dividends, which are cash paid to stockholders and estimated future growth of the same.
Share valuation is a mechanism used to determine a company’s value by estimating the value of its stocks. It is especially used when a business is in the phase of being sold, merged, acquired, etc.
Fundamental analysis is one of the many aspects that go into predicting a stock price. A stock price is often determined and influenced by both fundamental and technical factors combined with market sentiments.
Value investing is a type of investment strategy in which investors pick stocks that seem to be trading below their intrinsic value. Value investors are always on the lookout for stocks that they think the market may be underestimating.
Investors often use metrics such as Price to book, price to earnings, free cash flow, etc while value investing. With the help of these metrics an investor can determine which shares are good to invest in depending on the attractiveness of their prices.