Last Updated on May 25, 2022 by Neera Bhardwaj
Warren Buffet always said, ‘Never invest in a business you cannot understand’. Buffet is a firm believer in the concept of value investing. He believes in investing in companies that have a high intrinsic value rather than a high market value.
The intrinsic value of stock is an important parameter for many investors who follow the value investing approach. Even analysts use the intrinsic value meaning when making speculations about future market movements. In this article we understand what intrinsic value is and how it is calculated.
Table of Contents
What is intrinsic value?
Loosely translated, intrinsic value means the actual worth. It can also be defined as the price which a rational investor is willing to pay for an asset at its given level of risk. If you look at the intrinsic value from a more technical aspect, it can be defined as the present value of all the future cash flows expected from an asset. This present value is calculated using a suitable discounting factor or discount rate.
Intrinsic value vs. market value
The intrinsic value of a share is quite different from its market value. The intrinsic value depicts the worth of the stock as measured by its return generating potential. This is determined using fundamental analysis of stock and statistical calculations. Meanwhile, the market value is what the investors are paying for the stock. It is determined by the demand and supply of the stock.
The market value and intrinsic value of stock are not usually the same. The difference is what helps investors make the right trading decisions. Here’s how:
If the intrinsic value is higher than the market value
If the intrinsic value is higher than the current market value of a stock, it means that the stock is undervalued. Though the stock has good potential, investors have not yet noticed it. For potential investors, this is a sign to buy such stocks. If you invest in such undervalued stocks, you would stand to gain when the price of the stocks rises in future as their inherent worth is recognized.
If the intrinsic value is lower than the market value
If the intrinsic value of a share is lower than its market value, it may indicate a time to sell off such stock. It depicts that the stock is overvalued and the possibility of a correction in prices may be due. You can consider selling off such overvalued stock to book your profits before the price tumbles. This is, however, not an absolute guarantee. There are stocks that are overvalued but continue to breach their 52-week highs.
How to calculate intrinsic value?
There are various ways in which you can calculate the intrinsic value of a security. One of the most common ways of doing so is the Discounted Cash Flow (DCF) method. Let’s understand:
The Discounted Cash Flow method
Under the DCF method, three primary steps are used to calculate the intrinsic value. These steps are as follows:
- First, you have to assess the expected future cash flows of the security
- Second, you need to calculate the present value of each of these cash flows
- Thirdly, you have to aggregate all the present values of cash flows to get the intrinsic value.
There is a specific intrinsic value formula to calculate all these three steps in one go. This intrinsic value formula is as follows:
Intrinsic value = {CF1 / (1+r)^1} + {CF2 / (1+r)^2} + {CF3 / (1+r)^3} ….. {CFn / (1+r)^n}
In this formula, CF is the cash flow for different years (1, 2, 3 and so on), ‘r’ is the interest rate earned by investing in another security, and, ‘n’ is the period up to which the cash flow is calculated.
To understand the intrinsic value formula with example, consider a security with a cash flow of Rs 1000 every year and an interest rate of 6%. The intrinsic value of the stock for a year would be {1000 / (1+0.06)^1} = Rs 943.40 (rounded-off).
Should this figure be more than the market price the stock trades at, you know the stock is overvalued, and should the market price be below Rs 943.40, this stock in our example may be considered undervalued, and may have the potential to rise in the future.
Besides the DCF method, other ways of calculating the intrinsic value are as follows:
The P/E method
Financial metrics can also be used to determine the intrinsic value of a stock. The Earnings per Share (EPS) and the Price-Earnings Ratio (P/E ratio) are used in a formula to calculate the intrinsic value. The formula is as follows:
Intrinsic value = EPS * (1+r) * P/E ratio
In the ratio, ‘r’ is the expected rate of interest from the security.
Asset-based valuation
This is the easiest way of calculating the intrinsic value of a company by using its balance sheet. In this method, the value of the company’s assets is deducted from the value of its liabilities to find its intrinsic value.
Restrictions of using the intrinsic value
Though the intrinsic value is quite useful in determining the worth of a security, it has certain limitations too.
Calculating the intrinsic value is subjective. The value of the discounting factor and the expected cash flows is based on assumptions. If there is an error in such assumptions, the overall intrinsic value changes considerably. Different analysts can calculate different intrinsic values based on what they assume to be the right discounting factor and expected cash flow.
Also, the intrinsic value uses future predictions about the cash flow. Since the future is unpredictable, the value might not give the right picture of a stock.
To create a quality portfolio, you need to indulge in a broader assessment of stocks. Though stocks with good market sentiments can give you good returns, stocks with a high intrinsic value can prove to be instrumental for long-term growth. So, assess the intrinsic value along with the market value of stocks and then make your investment decisions.
