What is the Intrinsic Value of a Stock – Its Formula, Calculation and Methods
Intrinsic value is an asset’s total worth, including its tangible and intangible factors. It is the real worth of a share, which may or may not be similar to its market value.
Every asset carries an intrinsic value owing to its special quality. For instance, gold has a high intrinsic value owing to the challenging mining procedure. The intrinsic value of a share lets investors know its true worth based on an analysis of its actual market performance.
Factors like a firm’s target market or business model play a major role in managing a stock’s intrinsic value. If the market price happens to be below that value, it could be a profitable investment.
Why Is Intrinsic Value Important?
The intrinsic value of a stock is a great tool for comparative analysis. It helps an investor determine whether that particular stock is worth its current market price. Stockbrokers consider it a good ‘sale’ if the market price exceeds its intrinsic value. On the other hand, if a stock’s intrinsic value is higher than its current market value, investors may consider it a good ‘buy’.
This valuation tells investors whether a particular stock is actually worth its price. Value investors, who have the goal of buying stocks at a discount, use a stock’s intrinsic value to find the best bargains.
Formula of Intrinsic Value
There is no standard formula to calculate the intrinsic value of a stock. Instead, investors estimate this by anticipating how a stock might perform in future.
There are several methods to calculate the intrinsic value. Investors popularly use the discounted cash flow (DCF) method. Using this technique, investors and analysts can predict the business’s future cash flow. Furthermore, they can use it to determine a firm’s present valuation.
The DCF formula for the intrinsic value of shares is given below.
DCF= {CF1/ (1+r) ^1} + {CF2/ (1+r) ^2}+…..+{TV/ (1+r) ^ n}
Here,
- DCF = Discount cash flow or the present intrinsic value of the company
- CF = Cash flow for a particular year (CF1 for the 1st year, CF2 for the 2nd year, etc.)
- r = Discount rate
- TV = Terminal Value (multiple of cash flows in the final year)
Unlike intrinsic value of stocks, the intrinsic value of options follows a basic formula. This formula is given below:
Intrinsic value of options = (stock price- strike price of option)* Number of options
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What Are the Methods to Determine the Intrinsic Value of Stocks?
Analysts use various models to determine intrinsic values. Given below are a few methods that help to calculate intrinsic values of shares.
1. Discount Cash Flow (DCF) Analysis
This is the most popular model for evaluating intrinsic value of stocks. The DCF method considers the present value of the firm and its expected cash flow. In this method, one uses free cash flows to calculate the intrinsic value while excluding non-cash expenses such as depreciation.
2. Asset-Based Valuation Method
This model first takes a company’s tangible and intangible aspects into consideration. Following this, the liabilities are subtracted from assets to determine the stock’s intrinsic value.
3. Dividend Discount Model
Besides DCF, dividend discount is another popular model for evaluating a stock’s intrinsic value. This model takes into account the dividends offered by a company to its shareholders.
The dividend discount model has several variations upon which analysts assume variation to calculate intrinsic values. The Gordon Growth Model is a popular variation of the dividend discount model.
4. Comparable Analysis Based on a Financial Metric
Investors often use financial metrics like the price-to-earnings (P/E) ratio or earnings before interest, tax, depreciation and amortisation (EBITDA) to analyse the intrinsic value of stocks. Analysts use a relative evaluation technique to compare the value of stocks and businesses.
How to Calculate Intrinsic Value?
As stated earlier, investors and analysts use different formulas to calculate the intrinsic value of stocks. Besides the DCF model, here is a list of formulas you can use to know a stock’s intrinsic value:
1. Formula of Dividend Discount Model
The Gordon Growth Model is one of the most popular variations of the dividend discount model. The formula of the same is given below;
P = D1/ (r-g)
Here,
- P is the stock’s present value,
- D1= dividend of one year,
- r = required rate of return for the equity and
- g = annual growth rate of dividends in perpetuity.
2. Formula to Calculate Intrinsic Value Using the Asset-Based Ratio Method.
This method uses a simple and uncomplicated formula to calculate intrinsic value of stocks.
Intrinsic value = Sum of a company’s tangible assets and intangible assets – the company’s liability.
Please note, this technique can yield a lower intrinsic value for a company’s share than other methods.
3. Formula to Calculate Intrinsic Value Using Financial Metric
This is a quick method to determine a stock’s intrinsic value using the price-to-earnings ratio of a stock:
Intrinsic value of a share = EPS* (1+r)* P/E ratio
Here,
- EPS = Earnings per share
- R = Rate of return
- P-E ratio = Price-to-Earnings ratio
If manual calculations seem hectic and confusing, you can use various online calculators for intrinsic value calculations. These are easy-to-use many online tools that you can use to get accurate results in no time.
Example of Calculation of a Stock’s Intrinsic Value
Suppose a company called ABC Ltd generated earnings per share of Rs. 150/share for the last year. Its current P/E ratio is 15%. As per projected earnings, let’s say that ABC Ltd will offer returns of around 10.5% for the next 5 years.
Using the above-mentioned formula, the intrinsic value is:
(Rs. 150 per share) * (1 + 0.15) * 10.5 = Rs. 1811.25 per share
How Does Intrinsic Value Affect the Stock Market?
Intrinsic value can affect the stock market in the following ways.
- Intrinsic values help analysts evaluate the intrinsic value per share (IVPS). This determines whether the stock is overvalued, undervalued or fairly valued.
- The intrinsic value changes as per market conditions. Therefore, analysts can also use them to contemplate whether to sell the stocks or not.
- It helps investors to detect an opportunity to sell a company’s stock. If the intrinsic value of a share is high, they can sell the stock. However, if intrinsic value is low, they can grab the opportunity to make a purchase.
- It is essential for value investing as it allows investors to find stocks trading at a significant discount to their intrinsic value.
- Investors can find high-value stocks for long-term holding using intrinsic values.
What Are the Pros and Cons of Intrinsic Value Methods?
1. Pros:
These are some benefits of using intrinsic value methods:
- It ensures that investors purchase stocks whose market value is lower than the intrinsic value.
- It focuses on dividends and cash payments more than earnings.
- A detailed model structure of intrinsic value methods helps analysts foresee the company’s forthcoming cash flow.
2. Cons:
Intrinsic valuation has these disadvantages:
- The valuations are subjective. Analysts make assumptions about a company’s future cash flow to find out its intrinsic value, which could be inaccurate. This could also lead to considerable losses for investors.
- Intrinsic value calculations can be complex and incomprehensive for beginner investors. It also requires a good amount of expertise to build these models.
- Since intrinsic value misses the time value, failing to give an accurate picture of the company.
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Final Word
Analysts usually tweak the DCF model of intrinsic value to fit their requirements. However, this requires a good level of expertise in this field to understand its role in the present market. Investors, especially beginners, need to learn everything about calculating the intrinsic value of stock investments when researching firms. Though it is not a perfect metric, one can use it to get a general idea about realistic stock valuations.
FAQs
Essential value, terminal value, or principal value are a few other terms used to describe intrinsic value.
Intrinsic value is the sum of a company’s assets while subtracting its liabilities. However, market value is the current price of the company’s stock.
The ideal intrinsic value ratio is 1 when the current value of a company is at par with the fair market value or intrinsic value.
You can apply intrinsic value to those objects that have a tangible presence. However, cryptos do not fall into this category. As a result, you cannot attach intrinsic value to a crypto.
Yes, oil does have intrinsic value owing to its utility purpose in our life.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
