Before you invest in any stock, you must know the intrinsic value of the stock. The intrinsic value of the stock gives you the actual worth of the stock. There are different ways of calculating the stocks' intrinsic or true value. You must know how to find the stock's intrinsic value if you are an active investor in the stock market.
You might be intimidated by the concept and its calculation. However, you need to know the stock's actual value before investing. You can trace an investment opportunity by comparing the stock's market value with its estimated intrinsic value. The intrinsic value also helps you in calculating your expected returns.
The Intrinsic Value of Stocks
Before we understand how to calculate the intrinsic value of a share, let's get a glimpse of what Intrinsic value is. People might use the terms intrinsic value and the market value of stock interchangeability. However, these concepts are quite different from each other.
An investor can better understand a share's true value by looking at its intrinsic value. This is decided by considering the potential financial gain from a share in the future. Tangible and intangible factors influencing a share's value are considered when calculating intrinsic value.
Investors can determine the highest price at which they should purchase a share using the intrinsic value of a share.
Why is Calculating Intrinsic Value Useful?
Calculating the intrinsic value of the shares is quite important as it factors in both the qualitative and the quantitative aspects of the share. Calculating the intrinsic value is the first step toward conducting a fundamental stock analysis. Therefore, you need to know how to calculate the intrinsic value of a stock.
Also, only if you calculate the share's intrinsic value will you get a benchmark to compare it with the stock's current market price. As the calculation of the intrinsic value includes different values from the financial statements, it gives you a true picture of the performance of the stocks.
How to Find the Intrinsic Value of a Stock?
There are different ways of finding the intrinsic value of the stock. You must know how to calculate a stock's intrinsic value using these methods to use the information available effectively. Let's have a look at different ways in which you can calculate the intrinsic value of a share.
● Discounted Cash Flow Analysis
The discounted cash flow analysis is the most commonly used method of calculating the intrinsic value of a share. It is also known as the DCF analysis. You need to perform three simple steps while using this method to calculate the intrinsic value:
● Calculate the future cash flow of the company whose stocks you plan to invest in.
● Now, calculate the present value of all the estimated future cash flows.
● Calculate the sum of all these present values to arrive at the share's intrinsic value.
Calculating the future cash flow of the company is quite challenging. You will have to analyze the company's financial statements to estimate future cash flows. Also, you will have to go through news articles and editorial pieces to understand the company's growth.
The formula used in this method of calculating the intrinsic value of the share is:
Intrinsic value = (CF1)/(1 + r)1 + (CF2)/(1 + r)2 + (CF3)/(1 + r)3 + ... + (CFn)/(1 + r)n
CF shows the cash flow, where CF1 is the cash flow of the 1st year, and so on.
'r' is the rate of return based on the existing market standards.
● Analysis Based on a Financial Metric
Another popular way of calculating the intrinsic value of a share is conducting an analysis based on a financial metric. Popular ratios like the price-to-earnings ratio, etc., can be used to calculate the share's intrinsic value.
However, to use this metric, you must have the information available to help you calculate the P/E ratio. The formula to calculate the intrinsic value of the share using this method is:
Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio
Here, r stands for the expected growth rate of the earnings.
● Asset-Based Valuation
You can also use the asset-based valuation method to calculate the share's intrinsic value. New investors use this method as it does not involve complex calculations of the future and the present values of the company's cash flow. The formula used in this method is:
Intrinsic value = (Sum of a company's assets, both tangible and intangible) – (Sum of a company's liabilities)
However, this method does not consider any growth prospects of the company. Hence, the intrinsic value calculated using this method will not aid you in making relevant comparisons and may also not give you a true picture of the actual value of the share.
● Calculating the Intrinsic Value of Options
Considering investing in options, you must know how to calculate the intrinsic value. As options have concrete figures and metrics, there is no need to estimate any value that will help you arrive at the option's intrinsic value. The formula for calculating the intrinsic value of an option is:
Intrinsic value = (Stock price-option strike price) x (Number of options)
Let's take an example to understand this better.
If a stock is trading at INR 450 per share and you have four call options, you can buy 100 shares at every call at INR 400. You can calculate the intrinsic value of the share as follows:
(INR 450 – INR 400) * 50 = INR 2500
● Dividend Discount Models
Different models factor in the cash element while calculating the intrinsic value of a share. The dividend discount model, or the DDM, is one of the most popular methods analysts use to arrive at the stock's intrinsic value.
The formula used to calculate the intrinsic value using this method is:
The Value of the Stock = EDPS / (CCE -DGR)
● EDPS is the Expected Dividend per Share
● CCE is the Cost of Capital Equity
● DGR is the Dividend Growth Rate
In the absence of any of these values, you will not be able to use the dividend discount model to calculate the value of the shares. Several dividend discount models, like the Gordon Growth Model, etc., can be used to calculate the present value of the stocks.
● Residual Income Models
You can also use the residual income models to calculate the value of the shares. The formula that can help you calculate the value of the share is:
V0 = BV0 + S (RIt / (1 + r)t)
BV0 is the existing book value of the company's shares
RIt is the residual income of the company for a particular period
And r is the cost of equity.
Here, the formula uses the difference between the EPS and the book value of the share to calculate the intrinsic value of the share.
You can better comprehend the financial returns of a stock by looking at the intrinsic value of the share. To put it another way, it represents the true worth of a share. You must comprehend the use cases for estimating the intrinsic value if you are an active investor.
You can use any of the methods discussed above based on the values that are available to you. Remember that market and intrinsic value are not the same while understanding the stock's performance.