Intrinsic value showcases the actual worth of a particular asset. It is usually confused with market value. However, both concepts are different. Calculating intrinsic value can be challenging, but helps determine an asset’s true value. Read on to learn everything about intrinsic value.
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Intrinsic value meaning
The intrinsic value of a share helps an investor understand its true value. This is determined by considering the future monetary benefit that will be received from a share. The calculation of intrinsic value involves tangible and intangible aspects that affect the value of a share.
The intrinsic value of a share helps investors understand the maximum value at which they should buy a share.
Intrinsic value – Important Points!
- The intrinsic value of the shares depicts the true value based on the monetary benefit it can bring in the future.
- The intrinsic value and the market value of a share may or may not be the same.
- There are different methods of calculating the intrinsic value.
Breaking down the intrinsic value
The intrinsic value of a share involves quantitative as well as qualitative factors.
Several value investors compute the intrinsic value of a share by conducting fundamental analysis. Here, the investors consider several quantitative factors like the model on which the business operates, governance norms, the current market value of the shares and more.
The quantitative factors that the investors consider while calculating the intrinsic value of the shares may include the analysis of financial statements etc.,
Once you determine the intrinsic value of a share, you can compare it with the current market value to understand if the share is under or overvalued.
How to calculate intrinsic value?
The calculation of the intrinsic value is done through various approaches. Let’s look at two of them.
1. Discounted Cash Flow (DCF) formula
Long for DCF, discounted cash flow is a method used to ascertain the value of an investment or a stock based on the free cash flows expected to be generated by the company. These future cash flows are discounted to arrive at their present value by applying a discount rate.
The discounted cash flow analysis assumes that a rupee earned today is better than one earned tomorrow. The rationale is simple. If you invest the rupee that you have in your hand today, you can increase its value subsequently. That is also the whole point of investing.
Steps to calculate discounted cash flow
You can analyse the DCF of stock in three simple steps:
- Forecast the future cash flows from an investment
- Arrive at an accurate discount rate and apply it to the future cash flows to ascertain their present value
- Add these discounted future cash flows and the terminal value of the stock or the present value of the expected future selling price of the stock
Notes:
- To arrive at the discounted future cash flows of the company, apply an accurate discount rate to all the future cash flows through the holding period and then add them.
- Typically, the discount rate is a company’s Weighted Average Cost of Capital (WACC). This represents the required rate of return that you, as an investor, expect from buying their stock.
- Terminal value of stock = {CF*(1+growth rate)}/(discount rate – growth rate). Here, CF is the net cash flow.
Alternatively, you can also ascertain the DCF of stock using the following formula.
Intrinsic value = CF1/(1+r)1 + CF2/(1+r)2 + . . . + TV/(1+r) n
Here,
- CF = Expected cash flow for a specific period (e.g., CF1 = cash flow year one)
- r = Discount rate
- TV = Terminal value (estimated cash flow after the projection period)
- n = Specific period (e.g., years, quarters, months, etc.)
For this method, you must calculate the future cash flow of the company, which can be a challenging task. You can analyse the company’s financial statements to estimate future cash flows.
DCF is used by both investors and businesses. As an investor, you can use it to make calculated decisions when investing in the stock of a company. Businesses, on the other hand, use DCF analysis as part of their decision-making process when acquiring a company, doing capital budgeting or calculating operating expenditures.
If the intrinsic value of a stock derived using discounted cash flow analysis is more than its current price, then it would generate positive returns. If it is lower than the current price, the stock could generate negative returns.
Note that the DCF is not the same as the Net Present Value (NPV). The latter has an additional step of deducting the upfront cost of the investment from the DCF.
Shortcomings of the Discounted Cash Flow method
- DCF is based on many assumptions, such as the estimated future cash flows from the investment. The future cash flows are, in turn, based on a number of factors, such as the state of the economy, market demand, technology, competition, contingencies, and potential opportunities. Ergo, the discounted cashflows could be inaccurate.
- DCF is not feasible when you cannot determine the future cash flows. Ergo, at such times, it is best to use other methods to calculate the intrinsic value of stock.
- An unrealistically high estimate of the future cash flows can make an otherwise impractical investment look feasible. And if you go ahead and invest in the same, you may end up earning lower profits or incur a loss. In contrast, a low estimation of future cash flows can make the investment look expensive, discouraging you from an otherwise attractive opportunity.
2. Dividend Discount model
Also known as DDM, in short, the dividend discount model predicts a stock price based on the present value of the sum of its future dividend payments. In other words, it discounts the sum of all the future dividends expected to be offered by a company to arrive at their present values. If the stock price derived from the DDM is higher than the current value, it is undervalued, and if it is lower, the stock is overvalued. That said, if you opine that a stock is significantly overvalued, you may not buy it. In contrast, if you are of the opinion that the stock is significantly undervalued, it could be a good buy.
Discounting factor
Estimating the future dividends of a company in order to discount them requires certain assumptions. You could, maybe, identify historical trends of the dividend payments to estimate future dividends. You then take cues from it to calculate the intrinsic value of a stock based on the dividend discount model. For this purpose, you need two factors handy: r and g.
Estimating the r: when you invest in a stock, you take a risk in terms of a probable decline in its value. In return, you expect to be compensated, which is represented by the firm’s cost of equity capital. This is called the expected rate of return and is represented by ‘r’. You can estimate r by using the Dividend Growth Model or the Capital Asset Pricing Model.
Estimating the g: this variable represents the dividend growth rate of a company. If the growth rate is constant, then ‘g’ will be 0
One of the effective ways of discounting future dividends is by deducting the dividend growth rate from the expected rate of return (r – g).
Intrinsic value = [EDPS/(r-g)] + Present value of the expected selling price of the stock
Here,
- EDPS = Expected Dividend Per Share
- r = The cost of equity capital
- g = The dividend growth rate
Notes:
- To estimate the dividend growth rate, multiply the return on equity (ROE) by the retention ratio.
- The retention ratio is the opposite of the dividend payout ratio or 1 minus the dividend payout ratio. If the latter is 1%, the retention ratio would be 99%.
- The rate of return on the stock has to be more than the growth rate of future dividends.
Shortcomings of the Dividend Discount model
- There are chances that a company pays dividends even when incurring a loss or whose earnings are relatively lower. The DDM fails to take this possibility into account.
- All three variables of the formula to calculate the intrinsic value of a stock are estimates, which can render an inaccurate result. For instance, the dividend may grow at a constant rate, a higher rate or even a lower rate. This could still work in the case of a company that has displayed a constant dividend payout in the past years. However, it will not work in the case of a company that doesn’t pay constant or regular dividends.
- The dividend discount model fails when ascertaining the intrinsic value of a stock of a company whose rate of return is lower compared to its dividend growth rate. In this case, you can use the discounted cash flow analysis.
3. Analysis using financial metrics
Financial metrics can also be used to determine the intrinsic value of a stock. The Earnings per Share (EPS) and the Price-Earnings Ratio (PE ratio) are used in a formula to calculate the intrinsic value. The formula is as follows:
Intrinsic value = EPS * (1+r) * PE ratio
Here, ‘r’ is the expected rate of interest from the security.
You can use any of these formulas based on the information you can access. To get information about a company’s PE ratio and Earnings Per Share, check out Tickertape’s Stock Pages. They are equipped with every information you need to analyse a company. Explore them now!
4. Relative valuation method
This method compares the stock price with the company’s fundamentals, such as revenue, net income, profits, and the book value of equity shares. When you buy a stock, it makes you a part-owner of the company issuing it. As a result, you also own a portion of these key fundamentals.
The relative valuation method of deriving the intrinsic value of a stock involves comparing the company’s fundamentals, such as the PE ratio and book value of equity shares, with that of their peers.
One of the key ratios you can use for relative value analysis is the PE ratio. So if the stock price is Rs. 100 and the company’s earnings per share is Rs. 10, the PE ratio will be Rs. 10. This means that you pay Rs. 10 for each rupee of the company’s earnings. To see if this price is fair, compare it with the PE ratio of the company’s peers. If the company’s PE ratio is lower than the average PE of its competitors, you get the stock for a cheaper price and vice versa.
Shortcomings of the relative valuation method
In this method, you consider the company’s fundamentals as of today. However, these figures are subject to change with important developments within the company and the economy. This will certainly have a significant impact on the value of the stock.
Intrinsic value formula
Here’s a brief of the different types of formulas used to calculate the intrinsic value.
DCF method
Intrinsic value = CF1/(1+r)1 + CF2/(1+r)2 + . . . + TV/(1+r) n
Here,
- CF = Expected cash flow for a specific period (e.g., CF1 = cash flow year one)
- r = Discount rate
- TV = Terminal value (estimated cash flow after the projection period)
- n = Specific period (e.g., years, quarters, months, etc.)
Dividend Discount model
Intrinsic value = [EDPS/(r-g)] + Present value of the expected selling price of the stock
Here,
- EDPS = Expected Dividend Per Share
- r = The cost of equity capital
- g = The dividend growth rate
The financial metric formula for intrinsic value
Intrinsic value = EPS * (1+r) * P/E ratio
In the ratio, ‘r’ is the expected rate of interest from the security.
Risk adjusting the intrinsic value
The risk adjusting of intrinsic value does not solely depend on a formula.
Let’s look at the two commonly used risk-adjusting methods in calculating a share’s intrinsic value.
- Present value method
The present value method is widely used to determine the intrinsic value of a stock. This method assesses the present value of the expected cash flows from owning the stock, taking into account the time value of money. The basic idea behind this method is that the value of a rupee received in the future is worth less than the rupee received today.
To calculate the present value, you need to first estimate the expected cash flows from the stock, including dividends and other gains. Then using a discount rate (calculated based on several factors), the future value of cash flows is reduced to the present value. The resultant figure is the maximum price that an investor would be willing to pay for the stock.
By comparing the value to the current stock price, you can determine if the stock is undervalued or overvalued. If the present value is higher than the current price, it may indicate that the stock is undervalued and vice versa.
- Relative value method
Several investors use the relative method to calculate the intrinsic value of the shares. Here, you need to compare the stock price with the company’s expected value. For this, you may analyse a company’s fundamental values from its financial statements, revenues, profits, etc.
When you invest in a company or buy stocks, you get a percentage of these fundamentals. You try to maximise profits by getting a share of these fundamentals at the lowest price possible. Hence, you can use the PE ratio and the earnings per share to understand how much you are paying for a rupee of return.
The relative value approach to calculate the intrinsic value is:
Intrinsic value = Price to earnings ratio * Earnings per share
Why is intrinsic value not preferred in technical analysis?
While intrinsic value is a great way to understand the true value of the shares, it is not used during technical analysis. Some of the reasons for the same are:
- Intrinsic value is considered unstable as it is based on the value of the company’s fundamentals, like sales, profits, etc. These values are highly dynamic and are usually different every financial year.
- Intrinsic value estimation is only limited to shares. You cannot use it to predict the true value of assets like commodities, currencies, etc.
- Also, the intrinsic value of shares can sometimes mislead you as the market value may never reach the estimated intrinsic value.
The intrinsic value of call option
A call option’s intrinsic value shows the value by which the strike price of an option will yield profits. You can calculate the intrinsic value of the call option using the following formula:
Intrinsic value of a call option = Underlying current price of the stock – Call strike price
The formula helps understand the advantage of exercising an option immediately.
The intrinsic value of the put option
The put option’s value increases when the stock price is lower than the strike price. You can calculate the intrinsic value of the put option using the following formula:
The intrinsic value of a put option = Put strike price – Underlying current price of the stock
Intrinsic value Vs market price
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 a 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 will stand to gain when the price of the stocks rises in future as their inherent worth is recognised.
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.
Conclusion
The intrinsic value of the share helps you understand the financial returns of a stock. In other words, it depicts the true value of a share. If you are an active investor, you must understand the use cases for calculating the intrinsic value. It can be done using the present value or relative value method.
