Graham Intrinsic Value

Benjamin Graham, who is referred to as the ‘father of value investing’ bought a revolution in the stock market with his idea of intrinsic value and value investing methods.

To date, value investing and intrinsic value are used full-fledged in investing and now in trading as well and this article will help you understand Graham’s intrinsic value and how it is used by both investors and traders in present times.

Stock Analysis using Graham Intrinsic Value

Know everything about Graham’s Intrinsic value and how it was derived.

What is Graham’s Intrinsic value?

To understand what intrinsic value is, let’s know about the person who discovered it first, Benjamin Graham.

While he elaborated on value investing and intrinsic value in his second book “ The intelligent investor”, in his first book, written along with David Dodd, “Security Analysis” he first mentioned value investing and intrinsic value.

Before this book “Security Analysis” the stock market was referred to as a place for gambling and speculation. With the concepts of value investing, Graham changed the way people look at the stock market today.

In this second book, which we all refer to date “The Intelligent Investor” he explained how value investing works, how to calculate intrinsic value and the perks of value investing, and a lot more amount rightly investing in the markets.

As per Graham, Intrinsic value is the fair value of any asset irrespective of its market value. Intrinsic value is derived by means of different calculations of cash flow, profits, losses of a company, growth prospects, and other aspects.

While market value is mainly decided by the demand and supply of the asset, the intrinsic value gives the real idea of the real value of the asset.

In today’s time, there are trading platforms, and traders who have developed an indicator for determining the intrinsic value of the asset, this is known as Graham’s intrinsic value indicator.

Taking a cue from the intrinsic value, the value investing concept has been derived. Value investing refers to investing strategy which involves investing in assets whose market prices are lower than their intrinsic value.

Suppose, ABC company’s stock is trading at Rs. 2000 today, now after calculating its intrinsic value, you found out that the fair value of the company should be Rs. 3500.

So, as per Graham, every asset price will eventually match the intrinsic value. Thus, if ABC company is undervalued today, it is time to invest in it and wait until the price reached its intrinsic value.

So, there will be an increase in the value of your investment if you implement this concept and this is what value investing is all about.

Similarly, an asset may be overvalued as well, in that case, you must sell off the asset as the price will eventually reverse and fall towards the intrinsic value.

Intrinsic Value Calculation

While Graham calculated intrinsic value in a very complex way, with time, the calculation of the intrinsic value has been simplified without losing its actual meaning and importance.

You can calculate the intrinsic value of an asset using any of these 3 methods –

1. Discounted Cash Flow Analysis Method
2. Using Financial Metric – EPS and P/E Ratio
3. Asset-based valuation

Discounted Cash Flow Analysis Method

This is the most commonly used method for intrinsic value calculation. Here you use –

• Future cash flows of a company by estimating them
• Then calculate the present value of those future cash flows by discounting them
• Then sum them all up to derive the intrinsic value of the company’s stock.

Therefore, the Intrinsic value =

{CF1/(1+r)^1}+ {CF2/(1+r)^2}+{CF3/(1+r)^3}…………..{CFn/(1+r)^n}

Here,

CF1 is the first year’s cash flow, CF2 is the second year’s cash flow, and so forth.

Then, ‘r’ is the rate of return your money could have generated if you invested it somewhere else.

Using Financial Metric – EPS and P/E Ratio

Another way to find out the intrinsic value is by using Earning per share and price to earnings ratio of the stock. Here,

Intrinsic value = EPS*(1+r)*P/E Ratio

Here, r is the expected earnings growth rate.

Asset-based valuation

This is one of the basic ways to calculate an intrinsic value which goes like this –

Intrinsic value = (Sum of all the assets of a company – tangible and intangible) – (Sum of all liabilities)/Outstanding number of shares

However, this method doesn’t consider any growth aspect of the company and thus doesn’t give a truly fair value to the company.

How to use intrinsic value?

Intrinsic value is primarily used by investors who are looking for long-term investments. However, with the advent of advanced technology, which helps in building your technical analysis tools, many traders develop an indicator that can depict the intrinsic value of an asset.

So, using this indicator, you can understand whether the asset is overpriced or undervalued. Suppose, Graham’s intrinsic value indicator is giving you the fair value of stock ABC as Rs. 1500 however, the stock is trading at Rs. 1700, so, the stock is already overpriced, and there is no meaning in investing or buying the stock.

You can rather short-sell if you are an intraday trader or a short-term trader as eventually, the price of the stock will come back to the intrinsic value only.

Conversely, if the market price of the stock is lower than the intrinsic value say Rs. 1100, then the stock can rise to Rs. 1500 and as a trader, you can go long and as an investor, you can also buy the stock and hold until the market price reaches the intrinsic value.

Graham’s number vs. intrinsic value

Graham’s number is similar to Intrinsic value however, it is determined by using the earnings per share (EPS) of a company and its book value per share (BVPS).

This number is actually referred to as the upper limit of the price that an investor should pay for any stock. So, if Graham’s number is say Rs. 1000 and the stock is trading above it say at Rs. 1200, then the stock is overpriced.

According to Graham’s number, if the stock is trading below the number then only one should invest in it.

Graham’s number has been derived by using the formulae –

Graham’s number =

While Graham’s number is similar to intrinsic value, it doesn’t consider the growth aspect, the quality of management, major shareholders, and many other fundamental factors.

Why use Graham’s intrinsic value?

Benjamin Graham’s intrinsic value has immense importance in the world of the stock market. While many of us follow Warren Buffet, one of the world’s top investors, Benjamin Graham is the person who mentored Warren Buffet!

You can use intrinsic value for multiple reasons –

• It’s easy to use, and now with Graham’s intrinsic value indicator, you don’t have to even calculate it.
• Intrinsic value can be used by both traders and investors for both short-term and long-term. However, value investors benefit more from the intrinsic value determination when they buy the stocks at a lower price and the intrinsic value is higher than the market price and waits for the market price to reach the intrinsic value.
• Graham’s intrinsic value helps in determining which stock to buy and which not to. It also helps you understand the fundamental analysis of the company.

Conclusion

Whether you are trading or investing for the long-term, you would want to see your investment provide you a return, isn’t it? That is only possible when there is a price difference in the market price of the asset and the fair value.

Intrinsic value helps you find the fair value of the asset and in turn, if there is a mismatch with the market value, you can invest or trade for taking the opportunity of the price gap.