What is the intrinsic value of stocks?

Intrinsic value is a philosophical concept in which the value of an object or effort comes from itself—or, in layman’s terms, independent of other external factors. Financial analysts build models to estimate what they believe is the intrinsic value of the company’s stock, rather than the perceived market price on any given day.

The difference between the market price and the intrinsic value estimated by the analyst becomes the standard for measuring investment opportunities. Those who believe that these models are reasonable estimates of intrinsic value and will take investment actions based on these estimates are called value investors.

Some investors may be more willing to act based on their premonitions about stock prices, regardless of their company’s fundamentals. Others may make purchases based on the price movement of the stock, regardless of whether it is out of excitement or hype. However, in this article, we will study another method of calculating the intrinsic value of stocks by analyzing the fundamentals of stocks and determining their own value (in other words, how it generates cash).

Key points

  • Intrinsic value refers to some basic and objective values ​​contained in objects, assets or financial contracts. If the market price is lower than this value, it may be a good buy-if it is higher than a good sell.
  • When evaluating stocks, there are several ways to fairly evaluate the intrinsic value of stocks.
  • The model uses factors such as dividend flow, discounted cash flow, and residual income.
  • Every model critically relies on good assumptions. If the assumptions used are inaccurate or wrong, the value estimated by the model will deviate from the true intrinsic value.

Intrinsic value can also refer to the in-the-money value of an option contract. In this article, we only focus on stock valuations and ignore the intrinsic value applicable to call options and put options.

Dividend discount model

When calculating the intrinsic value of stocks, cash is king. Many models calculate the fundamental value of security factors in variables that are primarily related to cash (for example, dividends and future cash flows), and use the time value of money (TVM). A popular model for finding the intrinsic value of a company is the Dividend Discount Model (DDM). The basic formula of DDM is as follows:

Stock value = EDPS (CCE − DGR) where: EDPS = expected dividend per share CCE = cost of capital equity DGR = dividend growth ratebegin{aligned}&text{Value of stock} =frac{EDPS}{( CCE- DGR)}\&textbf{where:}\&EDPS=text{expected dividend per share}\&CCE=text{cost of capital equity}\&DGR=text{dividend growth rate}end{align }

Stock value=(CCSecondDGresistance)SecondDphosphorussecondWhere:SecondDphosphorussecond=Expected dividend per shareCCSecond=Cost of capital equityDGresistance=Dividend growth rate

A variant of this dividend-based model is the Gordon Growth Model (GGM), which assumes that the company under consideration is in a steady state—that is, the dividend increases permanently. It is expressed as follows:

P = D 1 (r − g) where: P = present value of the stock D 1 = expected dividend one year from now R = required rate of return for equity investors G = annual growth rate of perpetual dividend begin{ aligned} &P=frac{D_1}{(rg)}\ &textbf{where:}\ &P=text{present value of stocks}\ &D_1=text{expected one year from now Dividends}\ &R=text{rate of return required by equity investors}\ &G=text{annual growth rate of perpetual dividends} end{aligned}

phosphorus=(rG)D1Where:phosphorus=Present value of stockD1=Expected dividend in one year from nowresistance=Equity investor’s required rate of returnG=Annual growth rate of perpetual dividend

As the name suggests, it takes into account the company’s dividends paid to shareholders, which reflects the company’s ability to generate cash flow. There are many variants of the model, and each variant affects a different variable based on the assumptions you wish to include. Despite very basic and optimistic assumptions, GGM has its advantages when applied to the analysis of blue chip companies and broad indices.

Residual income model

Another way to calculate this value is the residual income model, which is expressed in its simplest form as follows:

V 0 = BV 0 + ∑ RI t (1 + r) t where: BV 0 = the current book value of the company’s equity RI t = the company’s residual income during tr = the cost of equity begin{aligned} &V_0= BV_0+sum frac{RI_t}{(1+r)^t}\ &textbf{where:}\ &BV_0=text{current book value of the company’s equity}\ &RI_t=text{a family within the period of residual income Company}t\ &r=text{cost of equity} end{aligned}

Volt=SecondVolt+(1+r)TonresistanceA generationTonWhere:SecondVolt=The current book value of the company’s equityresistanceA generationTon=The company’s remaining income in a certain period Tonr=Cost of equity

The key feature of the formula lies in how its valuation method derives the value of the stock based on the difference between the earnings per share and the book value per share (in this case, the residual income of the security), and thus the intrinsic value of the stock.

Essentially, the model attempts to find the intrinsic value of the stock by adding the current book value per share to its discounted residual income (which can reduce or increase the book value).

Discounted cash flow model

Finally, the most common valuation method used to find the fundamental value of stocks is discounted cash flow (DCF) analysis. In its simplest form, it is similar to DDM:

DCF = CF 1 (1 + r) 1 + CF 2 (1 + r) 2 + CF 3 (1 + r) 3 +… CF n (1 + r) n where: CF n = nd period cash flow = discount rate , Weighted average cost of capital (WACC)begin{aligned} &DCF=frac{CF_1}{(1+r)^1}+frac{CF_2}{(1+r)^2}+frac{ CF_3} {(1+r)^3}+cdotsfrac{CF_n}{(1+r)^n}\ &textbf{where:}\ &CF_n=text{Cash flow during the period}n \ & begin{aligned} d=&text{ Discount rate, weighted average cost of capital}\ &text{ (WACC)} end{aligned} end{aligned}

DCF=(1+r)1CF1+(1+r)2CF2+(1+r)3CF3+(1+r)nCFnWhere:CFn=Current cash flow nd= Discount rate, weighted average cost of capital (WACC)

Using DCF analysis, you can determine the fair value of stocks based on projected future cash flows. Unlike the previous two models, DCF analysis looks for free cash flow—that is, cash flow that does not include non-cash expenditures (such as depreciation) in the income statement and includes equipment and asset expenditures and changes in working capital. It also uses WACC as a discount variable to explain TVM.

Why intrinsic value is important

Why is intrinsic value important to investors? In the models listed above, analysts use these methods to see whether the intrinsic value of a security is higher or lower than its current market price, allowing them to classify it as “overvalued” or “undervalued.” Generally, when calculating the intrinsic value of stocks, investors can determine an appropriate margin of safety in which the market price is lower than the estimated intrinsic value.

By leaving a “cushion” between the lower market price and the price you think is worthwhile, you can limit the amount of decline that can result if the final value of the stock is lower than your estimate.

For example, suppose you discover a company within a year, and you believe that the company has strong fundamentals and excellent cash flow opportunities. It was traded at $10 per share that year, and after calculating its DCF, you realize that its intrinsic value is close to $15 per share: a bargain of $5. Assuming your margin of safety is about 35%, you will buy this stock for $10. If its intrinsic value drops by $3 after a year, you can still save at least $2 from the original DCF value, and if the stock price drops along with it, there is enough room to sell.

For beginners who understand the market, intrinsic value is an important concept to keep in mind when researching companies and looking for bargains that suit their investment goals. Although not a perfect indicator of a company’s success, applying a model that focuses on fundamentals provides a thought-provoking perspective on its stock price.

Bottom line

Every valuation model developed by economists or financial scholars is affected by the risks and volatility in the market and the complete irrationality of investors. Although calculating intrinsic value may not guarantee mitigation of all losses in the portfolio, it does provide a clearer indicator of the company’s financial status.

Value investors and others who are more willing to choose investments based on business fundamentals believe that this indicator is an important part of the successful selection of long-term stocks. From their point of view, choosing stocks whose market price is lower than their intrinsic value can help save money when building a portfolio.

Although the price of a stock may rise in a period of time, if it appears to be overvalued, it is better to wait until the market drops it below its intrinsic value to achieve bargaining. This not only prevents you from suffering more serious losses, but also provides room for maneuver to allocate cash to other safer investment instruments such as bonds and Treasury bills.

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