The intrinsic value of a stock is its true value. It refers to what a stock (or any asset) is actually worth even if some investors think it’s worth a lot more or less than that amount. Intrinsic value is a company’s, stock’s, currency’s, or product’s expected or calculated value based on fundamental analysis. It takes into account both tangible and intangible aspects. Intrinsic value, often known as real value, is not always the same as current market value. It’s also known as the price a rational investor is ready to pay for an investment based on its risk level.
How To Calculate The Intrinsic Value Of A Company
The present value of all future cash flows discounted at an appropriate discount rate is generally considered the fundamental or intrinsic worth of a firm or any investment asset. As, there is no universal standard for calculating the intrinsic value of a company, financial analysts build valuation models based on aspects of a business that include qualitative, quantitative and perceptual factors.
Before We move forward let us understand the 3 most commonly used ways to calculate the Intrinsic Value of a Stock: –
Discounted Cash Flow Analysis
Some analysts think that discounted cash flow (DCF) analysis is the best way to calculate the intrinsic value of a stock. To perform a DCF analysis, you’ll need to follow three steps:
Assess all of a company’s future cash flows
Calculate the present value of all the future cash flows.
Add up the present values to obtain the intrinsic value of the stocks.
The first step is the most difficult, by far. Assessing a company’s future cash flow requires you to use a few skills. You will probably need to research into the financial statements of the business (Previous cash flow statements could be a good place to start with). You’ll also need to gain a decent understanding of the company’s growth prospects to make educated guesses about how cash flows could change in the future.
Here’s the formula you can use to calculate an intrinsic value using discounted cash flow analysis:
Intrinsic value = (CF1)/ (1 + r) ^1 + (CF2)/ (1 + r) ^2 + (CF3)/ (1 + r) ^3 + … + (CFn)/ (1 + r) ^n
CF1 is cash flow in year 1, CF2 is cash flow in year 2, etc.
r is the rate of return you could get by investing money elsewhere
Let’s say you want to perform a discounted cash flow analysis for the stock of Tata Motors, a manufacturing company that makes a Cars. Suppose, you want to calculate the current cash flow statement and see that it generated cash flow of about Rs.100 million over the last 12 months. Based on the company’s growth prospects, you estimate that Tata Motors cash flow will grow by 5% annually. If you use a rate of return of 4%, the intrinsic value of Tata Motors would be a little over Rs.2.8 billion using discounted cash flows going out for 25 years.
Analysis Based On A Financial Metric
A quick and easy way of determining the intrinsic value of a stock is to use a financial metric such as the price-to-earnings (P/E) ratio. Here’s the formula for this approach using the P/E ratio of a stock:
Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio
where r = the expected earnings growth rate
Let’s say that Tata Motors generated earnings per share of Rs.5 over the last 12 months. Assume that the company will be able to grow its earnings by around 12.5% over the next five years. Finally, let’s suppose the stock currently it has a P/E multiple of 40. Using these figures, Tata Motors intrinsic value is:
(Rs. 5 per share) x (1 + 0.125) x 40 = Rs. 225 per share
Asset Based Valuation
The simplest way of calculating the intrinsic value of a stock is to use an asset-based valuation. The formula for this calculation is straightforward:
Intrinsic value = (Sum of a company’s assets, both tangible and intangible) – (Sum of a company’s liabilities)
What is Tata Motors intrinsic value using this approach? Let’s assume the company’s assets totaled Rs.450 million. Its liabilities totaled Rs.250 million. Subtracting the liabilities from the assets would give an intrinsic value of Rs.200 million for the stock.
There is a downside to using asset-based valuation, though: It doesn’t incorporate any growth prospects for a company. Asset-based valuation can often yield much lower intrinsic values than the other approaches.
Value investors can calculate the intrinsic value through fundamental analysis. An analyst must consider both qualitative and quantitative elements when using these methods.
The computed intrinsic value is then compared to the market value to determine if the asset is overpriced or undervalued.
Why Is It Beneficial To Calculate Intrinsic Value?
The purpose of value investing is to find stocks that are undervalued in comparison to their intrinsic value. There are various approaches for determining a stock’s intrinsic value, and two investors can have radically different (but equally legitimate) views on the same stock’s intrinsic value. The fundamental concept is to acquire a stock for less than it is worth, and calculating intrinsic value can assist you in doing so.Intrinsic value is an important factor to consider when evaluating a stock for investment purposes. There are several methods for determining the reasonable amount, and an investor should use the one that is most appropriate for the sector and features of the firm being reviewed.