Intrinsic Value of a Share or Stock

The intrinsic value of a share/stocks is the actual or projected value of the equity of a company according to its underlying business fundamentals, but not according to its current market value. It is based on the analysis of the earnings, cash flows, growth potential, financial strength as well as general business quality. Long-term investors should understand intrinsic value, as it enables them to determine whether a share is underpriced or overpriced in the market. A comparative approach would help investors use the intrinsic value of a stock to make better buying, holding, or selling decisions. This article discusses what is intrinsic value of share, factors that influence the intrinsic value of share, how to calculate intrinsic value of share, and more. 

Formula to Calculate the Intrinsic Value of Stock 

The intrinsic or fundamental value of a business or any investment asset is typically defined as the present value of all anticipated future cash flows, discounted at an appropriate rate. 

This approach is commonly represented by the net present value (NPV) formula, where the variables are interpreted as follows: 

NPV = Net Present Value 
CFi = Net cash flow for the ith period (for the first cash flow, I = o) 

R = interest rate 
n = number of periods 

Based on the above variables, intrinsic value can be calculated using different methods. 

How to Calculate Intrinsic Value of a Stock? 

Determining the intrinsic value of a stock is a crucial aspect of making informed investment decisions. Various methods are employed to estimate the true value of a company's shares, each offering different insights based on financial metrics and projections. Below are some of the most widely used techniques for calculating intrinsic value: 

1. Discounted Cash Flow (DCF) Analysis 

The Discounted Cash Flow (DCF) analysis is one of the most commonly used methods for estimating a stock's intrinsic value. This approach involves three main steps: 

Project the company's future cash flows, which requires a detailed analysis of its financial statements and growth prospects. 

Calculate the present value of these projected future cash flows. 

Sum the present values to determine the stock's intrinsic value. 

The formula for DCF analysis is:  

Intrinsic value = (CF1)/(1 + r)1 + (CF2)/(1 + r)2 + (CF3)/(1 + r)3 + ... + (CFn)/(1 + r)n 
 
Here, CF represents the cash flows, whereas CF1 refers to the cash flow in the first year, and so on. The variable r denotes the rate of return, which is determined based on prevailing market standards. 

2. Financial Metric-Based Analysis 

To understand what is intrinsic value of stock, there is another method for calculating intrinsic value that involves the use of financial metrics such as the Price-to-Earnings (P/E) ratio. To use this method, investors need to calculate the Earnings per Share (EPS) and estimate the growth rate of earnings (r). The formula for calculating intrinsic value using the P/E ratio is: 

Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio 

Where: EPS is the earnings per share. 

𝑟 represents the expected growth rate of earnings. 

3. Asset-Based Valuation 

This method focuses on the value of a company's assets and liabilities, offering a simpler approach without the need for future cash flow projections. It is typically used by newer investors due to its straightforward nature. The formula for this method is: 

Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio 

However, this approach does not account for the company’s growth prospects and may not provide a comprehensive assessment of the stock’s true value.  

4. Intrinsic Value of Options 

For investors considering options, calculating the intrinsic value is more direct since the value is based on the difference between the current stock price and the option’s strike price. The formula is: 

Intrinsic Value= (Stock Price−Option Strike Price) × (Number of Options) 

For example, if a stock is trading at ₹450 per share and an investor holds four call options to buy 100 shares at ₹400 each, the intrinsic value would be: 

(450−400)×50=2500 INR  

5. Dividend Discount Models (DDM) 

To know how to find intrinsic value of stock, there is another common method known as the Dividend Discount Model (DDM). It is commonly used by analysts to determine a stock's intrinsic value based on expected future dividends. The formula for this method is: 

Stock = EDPS / (CCE -DGR)    

 Where:  

EDPS is the Expected Dividend per Share. 

CCE is the Cost of Capital Equity. 

DGR is the Dividend Growth Rate. 

If any of these values are unavailable, the DDM cannot be applied effectively. Several variations of the DDM, such as the Gordon Growth Model, are also commonly used. 

6. Residual Income Models 

Residual Income Models (RIM) focus on the difference between a company’s earnings and its cost of equity, making them useful for estimating intrinsic value. The formula is: 

V0 = BV0 + S (RIt / (1 + r)t) 

Where: 

BV0 is the book value of the company's shares. 

RIt is the residual income for a given period. 

r is the cost of equity. 

This approach uses the residual income (the portion of profit exceeding the cost of equity) to calculate intrinsic value. After explaining how to calculate intrinsic value of a stock, the article further discusses the factors affecting stock intrinsic value.  

Factors That Affect the Intrinsic Value of a Share 

The following are the factors that affect the intrinsic value of a share.  

Earnings and Gains 

The intrinsic value of a share is directly impacted by the company’s regular income and gains. Higher and stable gains show not only strong business performance but also sustainability. 

Cash Flow Generation 

Strong and predictable cash flows reflect a company’s ability to meet obligations, reinvest in growth, and return value to shareholders, thereby increasing intrinsic value. 

Revenue Growth Potential 

Companies with steady or scalable revenue growth prospects generally have a higher intrinsic value due to their ability to expand earnings over time. 

Financial Strength and Balance Sheet 

Low debt levels, adequate liquidity, and efficient asset management improve a company’s intrinsic value by reducing financial risk. 

Management Quality and Governance 

Good corporate governance and effective leadership also contribute to long term performance and investor confidence, which is implicated in intrinsic value estimates. 

Industry Position and Competitive Advantage 

A strong market position, brand strength, or economic moat supports sustainable profits and enhances intrinsic value. 

Challenges with Intrinsic Value 

The following outlines several challenges associated with the intrinsic value approach: 

•  Subjectivity in Determining Intrinsic Value - The process of calculating intrinsic value is inherently subjective, as it requires making a variety of assumptions to project future cash flows. As a result, even minor adjustments to these assumptions can have a substantial impact on the final net present value (NPV), leading to significant variability in the valuation outcome. 
• Challenges in Calculating Weighted Average Cost of Capital (WACC) - The computation of the Weighted Average Cost of Capital (WACC) is fraught with complexity. Factors such as beta, market risk premium, and other variables can be interpreted and calculated differently by analysts, introducing variability. Additionally, the subjective nature of certain inputs, such as the probability factor, further complicates the accuracy and consistency of WACC calculations. 
• Uncertainty of Future Outcomes - The uncertainty surrounding future events is a major challenge in the intrinsic value approach. Given that different investors may have distinct perspectives on future developments, their valuations of the same asset can vary considerably. This disparity arises from the speculative nature of forecasting, which makes it difficult to establish an accurate and universally accepted valuation. 

 After understanding the intrinsic value of share meaning and challenges associated with it, the article further explains the difference between market value and intrinsic value.  

Difference Between Market Value and Intrinsic Value 

Here’s a table summarising the key differences between Market Value and Intrinsic Value: 

Importance and Limitations of Intrinsic Value 

The table below shows the importance and limitation of intrinsic value.  

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions. 

Conclusion 

The intrinsic value is considered the estimated true value of share, which is calculated by the fundamentals of the company and not the current price in the market. It is a key concept in the stock analysis as it assists the investors in analysing whether a given stock is under valued, fairly valued or overvalued. Intrinsic value calculation is speculative and based on assumptions and forecasts; however, it offers a structured process of decisions and is less dependent on price changes during short periods of time. For investors using a stock market trading app, understanding intrinsic value can improve analysis quality and support more informed buy, hold, or sell decisions based on fundamentals rather than price trends alone.