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What is Intrinsic Value of Stock?
The intrinsic value of a stock is the actual value or fundamental value (true value), which is determined through fundamental analysis. It is independent of market perceptions. The analysts consider all factors like qualitative, quantitative and perpetual factors to estimate the intrinsic value. The intrinsic value is also called the real value, which may or may not be the same as the current market value. It is the price the rational investor is willing to pay for an investment considering its level of risk.
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There are several methods to determine the fair value of a stock. These methods use dividend streams, discounted cash flows and residual income for calculation. However, these models are based on assumptions. If these assumptions are inaccurate, the estimated value will deviate from the actual intrinsic value. Therefore, determining this value plays an important role in the financial analysis of company stocks and helps investors choose the right stock for investment.
Importance of Intrinsic Value
The following is the importance of determining the intrinsic value –
- Intrinsic value is essential because it can help investors to understand if the stock price of a company is undervalued, fairly valued or overvalued in comparison to its current market price.
- If the stock price is lower than its intrinsic value, investors will want to accumulate more shares in anticipation of rise in prices. Otherwise, investors can limit the downside if the stocks fall below the estimated value.
- Similarly, it can determine whether a company’s stock price is overvalued. It helps to understand whether to hold the stock or sell it.
- Investors use this value while making decisions about a stock, whether to purchase it or not, for several reasons. Typically, investors can determine the margin of safety where the market price is below the estimated intrinsic value.
- It gives investors a gauge to determine how much they should pay for each share.
- While investing in an Initial Public Offering (IPO) of a company helps to determine whether the stock will be successful after its first day of trading.
- Sometimes investors also use Intrinsic value when creating indicators like the price-to-earnings ratio, as it measures this value over the years. Also, it helps to determine whether the market expectations are accurate and represent a good investment opportunity.
How to Calculate the Intrinsic Value of a Stock?
The following are the different models for calculating the intrinsic value of a stock –
1. Dividend Discount Model
The Dividend Discount Model, or DDM, estimates the intrinsic value based on the present value of the sum of its future dividend payments. In other words, the sum is the discounted value of all future dividends expected to be offered by the company to arrive at the net present value. If the stock price derived from the DDM is higher than the current market price, it is undervalued. Similarly, if the stock price is lower than the current market price, it is overvalued. The following formula to calculate under DDM is –
Intrinsic Value of Stock = EDPS / ( CCE – DGR )
Where,
EDPS – Expected dividend per share
CCE – Cost of capital equity
DGR – Dividend growth rate
Limitations
There are chances that a company may pay dividends while incurring losses or whose earnings are relatively lower. This model fails to consider this aspect.
- All three variables used in the calculation are estimates which can deliver inaccurate results. For instance, a dividend may grow at a constant rate, higher or lower rate. This model can work better for companies that provide regular dividend payments historically. However, this model is not so accurate in case the company does not provide constant or regular dividends.
2. Discounted Cash Flow Model
The discounted cash flow model, or DCF, is the most common valuation method used to calculate the stock’s intrinsic value. This method uses the time value of money to ascertain the intrinsic value based on the free cash flows that the company is expected to generate in future. These projected cash flows are discounted to arrive at the net present value by applying the discount rate.
Typically, the discount rate is the company’s weighted average cost of capital (WACC). This represents the required rate of return that you expect when you buy a stock as an investor. The value derived using this method is more than the current market price, the stock can generate positive returns and vice versa. The following is the formula under DCF –
Intrinsic value of Stock = {CF1/(1+r)^1} + {CF2/(1+r)^2} + {CF3/(1+r)^3} +……..+{CFn/(1+r)^n}
Where,
CF1 – Cash flow for year 1 and so on
CFn – Cash flow for N number of years
r – the discount rate
Limitations
- This model is based on assumptions of estimation of future cash flows. The projected cash flows are, in turn, based on several factors like market demand, economic conditions, technology, competition, potential opportunities, etc. This would result in inaccurate value.
- Sometimes, an unrealistic estimate of high cash flows can make the investment look feasible but may be impractical. And investing in stock may lead to earning low profits or incurring losses. In contrast, a low estimate of future cash flows can make the investment look expensive, discouraging you from investing in an opportunity.
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3. Relative valuation method
The relative valuation method is the most preferred method used to determine the intrinsic value of a stock. This method uses the current market value and the company’s fundamentals like revenue, net income, profits, book value, total outstanding shares, etc. This helps to understand whether the company stock price is undervalued or overvalued. Therefore, using various financial ratios helps to know how the company performs. Also, you can gauge the company’s overall financial health.
The key ratios that are used to determine the intrinsic value are –
- Price-to-book ratio
- Price-to-earnings ratio
- Price-to-growth ratio
- Return on equity
- Debt to Equity ratio
Alternatively, you can also use the Enterprise Value (EV) ratio to estimate this value –
- EV – Sales
- EV – EBITDA (Earnings before interest depreciation, tax and amortisation)
- Price sales ratio
Limitations
- While using this method, you consider the company’s fundamentals as of today. However, the figures are subject to change with developments in the company and economy. This will also have an impact on the stock value.
Risk Adjustments for Intrinsic Value
Risk adjusting in intrinsic value is how one can account for possible downward variations with cash flow fluctuations. This part of calculations is very subjective, and it is an amalgamation of both art and science. The following are the two methods to account for volatility and possible fluctuations –
1. Discount Rate
In the discount rate approach, the analyst will typically use the company’s weighted average cost of capital (WACC). The WACC formula consists of a risk-free rate (usually a government bond yield) plus the premium based on the stock volatility multiplied by the equity risk premium.
The rationale behind this approach is that if a stock is more volatile, it is a riskier investment. Also, an investor can expect higher returns. As a result, using a higher discount rate lowers the estimated future cash flow value.
2. Certainty Factor
Under this approach, you have to assign each cash flow to a certainty factor. Then multiply it by the total Net Present Value (NPV) to discount the investment. Thus, this strategy reduces the cost of investment. Because the cash flows are risk-adjusted, the risk-free rate is used as the discount rate under this approach. As a result, the yield rate and the discount rate are the same.
For instance, the cash flow from a government bond comes with 100% certainty. Thus, the discount rate is 7%. Similarly, a cash flow from a high-growth company has a 50% probability factor. The same discount rate can be used because the risk associated with the high-risk company is already factored in the probability number.
Challenges of Intrinsic Value
The following are challenges while computing the intrinsic value of a stock that investors should know before using it –
- The computation of the intrinsic value of a stock is a very subjective exercise. It involves projecting a company’s cash flows where the investor has to make many assumptions. Therefore, the net present value can vary drastically due to the changes in the underlying assumptions.
- Similarly, while computing the weighted average cost of capital (WACC), factors like beta, market risk premium, etc., have to be calculated separately. Hence, the probability aspect you use during calculations is also very subjective.
- When it comes to predicting the future, it is very uncertain. Hence, different investors arrive at different values for the same company or asset. This difference is because everyone has their own perspective during predictions. Also, there is no one way to determine the accurate number for intrinsic value.
To conclude, intrinsic value is critical in determining the stock’s value for investment purposes. Since there are different ways to evaluate the real value of a stock, you must use the method depending on the company’s sector and after considering the company’s unique characteristics.
Frequently Asked Questions
The intrinsic value is also referred to as fundamental value or fair value. Investors often use these terms interchangeably. This value represents the price at which the security shall actually trade.
Understanding the intrinsic value of a stock is important because it helps investors to decide whether the stock is undervalued, fairly valued or overvalued. Also, it helps to identify if the value is lower than its market price; it is a good buy. Similarly, if the value is higher than the market price, it is good to sell.
The market value of a stock is the current market price at which the stock is trading, and the investor pays for buying the stock on a stock exchange. The intrinsic value of a stock is the estimated real value based on the company’s financials and cash flows.
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