Here is a guide on how to calculate intrinsic value and why this value holds so much importance for investors.
When it comes to shares, you must always wonder what makes them have a certain price. The share price of certain stocks can be Rs. 100 or Rs. 1000 on a given day.
But experts will tell you that these prices are decided after taking into account the various market factors at the given time and day. This is not the intrinsic value of a stock. Then what is the intrinsic value of the stock?
Well, in simple terms, it is the value of the share which is derived from the stock itself without any interference from extraneous factors.
Financial analysts take into account the company’s fundamentals to derive the intrinsic value of the stock regardless of the market’s condition, hype, or excitement. Therefore, it is also called the fundamental analysis of the stocks.
Some investors instead of relying on the current price or the hype of the stocks in the market tend to utilize the fundamental analysis and intrinsic value of the stocks as a deciding factor.
These investors are called value investors. The difference between the intrinsic value of the shares and the market price of the shares tells the investment opportunity of the same.
Why is Intrinsic Value Important?
The intrinsic value of the shares is quite important for investors, and here are some of the reasons why:
- One of the major reasons to calculate the intrinsic value of a stock is to determine whether the stock in question is undervalued, overvalued, or fairly valued because the trading decision will depend on this information. In case the market value is lower than the intrinsic value, it means the stock is undervalued and is the right tie buy it at a cheaper rate. And in case it is overvalued, it is best to sell the stock before the price drops to the intrinsic value.
- In the case of IPOs, intrinsic value can be highly useful in determining the success rate of the shares. With a better fundamental study of the company’s current and past performance, the intrinsic value can give a better view of the pricing and performance of the shares on the share market.
- Another, thing that investors can learn about the shares using the intrinsic value is the margin of safety, if the price of the share is lower than the estimated intrinsic value, then the difference between the same is the margin of safety.
- At times, the investors can also use the intrinsic value of the shares to determine the indicators like P/E ratio. This can help the investors understand if their expectations are fair and if the opportunity of investment will reap good results.
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Calculating Intrinsic Value
Now, that you know what is the intrinsic value of shares, and then now you might want to know what is the process of its calculation. Well, finding the intrinsic value is quite easy if you know the three most common methods to do so.
Discounted Cash Flow Analysis
This is one of the most common models for finding the intrinsic value model. The calculation is based on the time value of money concept, that is, calculating the present value of future cash flows.
The cash flow considered in this concept is the “free cash flow”. It includes changes in working capital, non-cash expenses such as depreciation, and capital expenditure incurred due to changes in assets and equipment.
To calculate the value, the weighted average cost of capital is discounted over the period to reach the current intrinsic value. The formula goes as the following:
DCF = CF1 / (1 + r)1 + CF2 / (1 + r)2 + CF3/ (1 + r)3 + …. CFn / (1 + r) n
CFn = Cash flow in period n
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Residual Income Models
Another popular method of getting the intrinsic value of the stock is by using the residual income model. The major components of this model include the residual income of the shares, the earnings per share, and the book value.
This method is mostly used to discount the residual income of the per-share book value to the present time. The formula for the model is as follows:
V0=BV0+∑ RIt / (1+r) t
BV0 = current book value of the company’s equity.
RIt = company’s residual income at a given point in time.
r = Equity cost
Dividend Discount Models
Cash is one of the most crucial factors when it comes to deriving the intrinsic value of a stock. Several models in fundamental analysis use cash as their main variable while finding the fundamental value of a security type.
Usually, in these models, cash flow and dividends are taken into account alongside the time value of money.
One of the most crucial metrics that tell the investors and others about the company’s stability and its cash-generating capabilities is Dividends. This is the reason why the dividend discount model remains one of the most popular ones.
Among these models, the most popular one is the dividend discount model or DDM model.
The very basic formula of the dividend discount model is:
Value of stock = EDPS / (CCE-DGR)
EDPS= expected dividend per share
CCE= cost of capital equity
DGR= dividend growth rate
Gordon Growth Model
The Gordon growth model is calculated on the concept that the dividend of company growth is at perpetuity. And to discount it back to the present time, the following formula is used:
P = D1 / (r-g)
P = present value of the stock
D1 = expected dividend in 1 year from the present
r = required rate of return
g = annual growth rate in dividends
Conclusion
Those investors who value fundamental indicators and simply do not trust the market hype, find intrinsic value to be one of the most useful indicators of the health of the company.
Though you may not be able to mitigate the entire risk of their portfolio by simply taking into account the intrinsic value, it does remain one of the most useful steps in choosing the right type of stock to invest in.
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