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What is Intrinsic Value of a Share/Stock and How to Calculate: Meaning and Formula
What Is the Intrinsic Value Of A Share?
The intrinsic value of a stock or share is the anticipated or calculated current value of a stock, product, company, or currency. It is the measurement of the worth of the assets. This measurement can be done by calculating an objective or through a fundamental analysis method. The intrinsic value of a share is also known as real value and the price an investor is ready to pay after evaluating the possible risks.
The financial analysis involves determining a particular company's cash flow and underlying value. In terms of intrinsic value, however, it gives us the difference between the current price of an asset and its options.
Intrinsic Value Of Share Breakdown
Investors can calculate the intrinsic value with the help of fundamental analysis. An analyst needs to consider qualitative (like business model, governance, and market characteristics) and quantitative (like financial statement analysis) elements. One can then compare the computed intrinsic and market values to ascertain if the asset is overpriced or undervalued.
How To Calculate Intrinsic Value Of Share
The standard intrinsic value of a share formula is similar to that of the net present value, where the symbols represent as follows:
- CFi= net cash flow for the ith period
- r= interest rate
- n= number of periods
The risk involved in changing the financial flow is subjective. It combines art and science. There are two main approaches:
This strategy is based on the core idea that a stock's volatility indicates how risky an investment is and if an investor would benefit from it. The analyst typically employs a company's weighted average cost of capital under this strategy. The risk-free rate, which one obtains from the yield on government bonds, is generally included in the weighted average cost of capital, coupled with a premium determined by the stock's volatility multiplied by an equity risk premium. As a result, a higher discount rate is used in this scenario, which lowers the estimated future cash flow value.
Each cash flow has a certainty or likelihood factor in this approach, which we multiply by the total net present value (NPV). The investment is discounted using this technique. As the cash flows are risk-adjusted, this method uses the risk-free rate as the discount rate.
For example, the cash flow from the government comes with 100% certainty, making the discount rate equal the yield to approximately 2.5%. Compare this to a high-risk but high-growth technology company. The certainty would be about 50% with the same 2.5% discount rate.
Other Valuation Methods
Calculating the intrinsic value can be complex, especially for newbie investors. The main methods used in the industry to calculate the intrinsic value are as follows:
Method 1: Comparative Analysis
Comparative analysis is a technique called trading or public market multiples, equity comps, and peer group analysis. The approach uses the relative valuation technique, in which an analyst studies trade multiples like P/E, EV/EBITDA, or other ratios to compare the firm's assets to be valued to other similar companies. The technique gives the company a measurable value based on what other businesses are worth.
For instance, if Company B has earnings of Rs. 2 per share and Company A trades at a 10x P/E ratio, the value of each share of Company B stock is worth Rs. 20 (assuming the companies are entirely comparable).
Method 2: Transactions with Precedents
The comparable valuation approach compares the company to be evaluated to other businesses that have recently been sold or purchased in the same industry, which is similar to the method of precedent transactions.
These transactions are used to determine the company's value.
Method 3: DCF Analysis
The most popular method for determining intrinsic value is the discounted cash flow (DCF) method. Using the firm's Weighted Average Cost of Capital (WACC), the analyst projects the business's future cash flow and discounts it to its current value.
Let's take an example to understand further how fair value is established using this approach.
Assume you are assessing a business with the cash flow listed below.
Starting in 2019, the first five years' cash flow total- Rs. 100.
The discount rate- 10%
The terminal growth rate- 5%
The cash flow generated in 2019 is currently estimated to be -
= CF / (1+r)^n
= 100/ (1+10%)^1
= Rs. 91.
The current value is Rs. 91.
Perpetual growth is used to calculate terminal value. The formula is
= CF * (growth rate + 1) (discount rate – growth rate)
Consequently, the terminal value will, hence, be calculated as
= Rs. 2100
The current terminal value is Rs. 2100
Challenges In The Intrinsic Value Of A Stock
Calculating intrinsic value is challenging because it is such a personal endeavor. Numerous assumptions are a part of the process, and any changes to those assumptions will significantly impact the final net present value(NPV).
While calculating the WACC's assumptions about beta and market risk premium can differ, the assumption regarding a confidence or probability component is wholly arbitrary.
It is impossible to forecast the future since it is inherently uncertain. Due to this, even the world's most successful investors might use the same data to analyze a firm and come up with very different estimates of its intrinsic worth.
The goal of intrinsic value is to help identify the share you want to purchase for less than it is worth. Intrinsic values help you find stocks that are trading for less value and will not be a beneficial investment. We may find out a share's intrinsic value with several approaches. But if two investors were to calculate it for themselves, their opinion about the same share may be completely different but equally legitimate.