Learn what intrinsic value means, how to calculate it and why intrinsic value is important in investing.
What is a share worth? You could just go by the current share price, but this price is subject to the whims of the market. Another alternative is to determine the intrinsic value of the stock. The intrinsic value of a stock is its true value. It refers to what a stock (or any other asset) is actually worth - even if some investors think it is worth much more or less than the amount of money involved.
One might think that calculating intrinsic value is difficult. However, that is not the case. Not only can you determine the intrinsic value of a stock, but you can also use it to look for the best bargains on the market. Knowing the intrinsic value of an investment is useful, especially if you are a value investor who aims to buy shares or other investments at a discount.
How easy is it to calculate the intrinsic value of a stock? That depends on which calculation method you use, and yes, you can indeed from several methods. We’ll explore three of the most popular approaches.
Discounted Cash Flow Analysis
Some economists believe that discounted cash flow (DCF) analysis is the best way to calculate the intrinsic value of a stock. To perform a DCF analysis, you need to follow three steps:
1. Estimate all future cash flows of a company.
2. Calculate the present value of each of these future cash flows.
3. Add up the present values to get the intrinsic value of the stock.
The first step is by far the most difficult. To estimate the future cash flows of a company, you need to combine the skills of Warren Buffett and Nostradamus. You will probably need to delve into the company's financial statements (not surprisingly, past cash flow statements are a good starting point). You will also need to gain a reasonable understanding of the company's growth prospects in order to make educated guesses about how cash flows might change in the future.
Here is 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 the cash flow in year 1; CF2 is the cash flow in year 2, etc.
- r is the return you could earn if you invested the money elsewhere
Suppose you want to do a discounted cash flow analysis on the stock of RoboBasketball, (a fictional company that produces remote-controlled drones resembling basketballs). You look at the company's current cash flow statement and see that it has generated USD 100 million in cash flow over the last 12 months. Based on the company's growth prospects, you estimate that RoboBasketball's cash flow will grow by 5% per year. If you use a 4% rate of return, RoboBasketball's intrinsic value would be just over USD 2.8 billion based on discounted cash flows for 25 years.
Analysis based on a financial ratio
A quick and easy way to determine the intrinsic value of a share is to use a financial ratio such as the price-earnings ratio (P/E ratio). Here is the formula for this approach using the price-earnings ratio of a share:
Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio.
where r = the expected earnings growth rate.
Let us assume that RoboBasketball has generated earnings per share of USD 3.30 in the last 12 months. Assume that the company will be able to grow its earnings by about 12.5% over the next five years. Finally, let us assume that the share currently has a P/E ratio of 35.5. Using these figures, the intrinsic value of RoboBasketball is:
(USD 3.30 per share) x (1 + 0.125) x 35.5 = USD 131.79 per share.
The simplest way to calculate the intrinsic value of a share is 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).
Using this approach, what is the intrinsic value of RoboBasketball? Let us assume that the company's assets amounted to USD 500 million. The liabilities were USD 200 million. Subtracting the liabilities from the assets gives an intrinsic value of the share of USD 300 million.
However, there is a drawback to using asset-based valuation: it does not take into account growth prospects for a company. Asset-based valuation can often yield much lower intrinsic values than the other approaches.
Calculating the intrinsic value of options
There is a rock-solid method for calculating the intrinsic value of stock options that requires no guesswork. Here is the formula:
Intrinsic value = (Stock price-option strike price) x (Number of options).
Suppose a particular stock is trading for USD 35 per share. You own four call options that entitle you to buy 100 shares per call option for USD 30. What is the intrinsic value of your options? The calculation is simple:
(USD 35 – USD 30) x (400) = USD 2,000.
Options that are not in the money, i.e. the strike price is greater than the current share price, have no intrinsic value and are traded only for time value (i.e. the potential that the share price could rise and drive the option price up).
Why calculating intrinsic value makes sense
The goal of value investing is to seek out stocks that are trading for less than their intrinsic value. There are different methods of assessing the intrinsic value of a stock, and two investors can form two completely different (and equally valid) opinions about the intrinsic value of the same stock. However, the general idea is to buy a share for less than its true value, and assessing the intrinsic value can help you do just that.
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