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How to calculate Intrinsic Value

Intrinsic Value is the fair or fundamental value of a stock that considers both tangible as well as intangible factors, irrespective of value assigned by the market.

Most investors believe that stocks are usually mispriced at various times will eventually hover around its intrinsic value.

And therefore the main objective of fundamental analysis is to determine the Intrinsic Value of a stock, so that the investors can take advantage of the price mismatch prevailing in the market, and accordingly place their investment bets.

Ways to determine Intrinsic Value

Intrinsic value is basically a philosophical concept and investors can arrive at a stock’s intrinsic value by simply relying on their “gut feeling” or base their investment on some “hype” about the stock.  

Intrinsic value is basically determined through absolute form of valuation that looks at the inherent value of stock based on the past financial performance and future growth potential.

So, here are few financial models which helps in determining the intrinsic value, thus reducing the subjectivity that revolves around this concept. 

Dividend Discount Model (DDM) - This model tries to determine the fair value of a stock by assuming that the value of a company is the present worth of the sum of all of its future dividend payments.

The formula used is:

Value of a stock = Expected dividend per share/(Cost of equity - Dividend growth rate)

This is represented as,

Value of a stock = D /(r-g)

This is the basic and most widely used variation of DDM which is also known as the Gordon Growth Model, named after American economist Myron J. Gordon.

It assumes stable dividend growth rate in perpetuity. Thus, not suitable for valuing companies that have fluctuating dividend growth rates or no dividend at all. Moreover, the model loses its essence, when the company has lower rate of return (r) compared to its dividend growth rate (g). 

However, this model has it has its own merits when applied to the analysis of very mature companies that have an established history of regular dividend payments.

Discounted Cash Flow(DCF) is the most widely used valuation model used to determine a stocks correct value. This method determines the Intrinsic Value of a company based on its estimated future Cash Flows. 

The formula used is:

 

                        DCF   =                             CF 1                  CF 2                 CF 3            CF n

                                                              _______    +    _______    +    _______   +    ______

                                                               (1+r)^1          (1+r)^2           (1+r)^3           (1+r)^n

Where;

CFn = Cash Flows in period n.

r = Discount rate (WACC)

This model uses the company’s free cash flow and the Weighted Average Cost of Capital (WACC).

The main issue with this model is that it is dependent on on 5-10 years of future cash flows, predicting which, is highly uncertain.

This model is well suited for companies having financial stability and business predictability.

Thus, from the above valuation models we understand that intrinsic value is the deemed value of a stock’s future cash flow, expected growth and risk, and also the concept of time value of money. 

Why does Intrinsic Value matters?

 Intrinsic Value is the elemental value used by value investors to analyze a company. And, the concept is to invest in companies that have a higher true value than what is being assigned by the market.

 Once, intrinsic value is determined, it can be compared with the prevailing market price to determine whether investment in the said stock will be profitable or not.

 Intrinsic Value > Market Price, indicates that the stock is underpriced.

Intrinsic Value = Market Price, indicates that the stock is fairly valued.

Intrinsic Value < Market Price, indicates that the stock is overvalued.

 Value Investors believe that in the long run stock prices tend to move towards its fair value and accordingly place their investment bets. That is, when the stock is undervalued they see it as a buying opportunity and they try to exit when the stock becomes overvalued.

Intrinsic Value and Margin of Safety

 As calculation of Intrinsic Value involves assumptions, it can never be 100% correct. Thus, decisions based on intrinsic value involve some uncertainty or risks.

So, in order to minimize this investors can add a cushion to the derived intrinsic value. This added cushion is known as Margin of Safety.

 Margin of safety can be calculated using the following formula:

 Margin of safety = (Intrinsic Value - Current Market Price) / Intrinsic Value

Margin of safety will be larger for undervalued stocks. On the other hand, margin of safety will be zero for fairly or overvalued stocks, making such shares subject to more risk.

In situation, where the risk free rates are relatively high, investors may assign larger margin of safety on their stocks and vice-versa.

Points to be remembered

  • Intrinsic Value is the estimated value of a stock, irrespective of how the market values it.
  • A stock trading below its intrinsic value is undervalued and provides a buy opportunity while a stock trading above its intrinsic value is overvalued and provides a sell opportunity.
  • It helps in making direct comparison among companies, even if they belong to different industrial sectors.
  • Every prudent investor should add a margin of safety, over and above the intrinsic value of a stock to minimize the uncertainties behind its calculation.
  • Calculating intrinsic value is not a guaranteed way of mitigating all losses, however it does provide a clearer indication of a company’s financial health, which is essential for stock selection.
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Wednesday, 11 December 2019

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