Intrinsic Value of Share

What is Intrinsic Value?

Intrinsic value refers to the estimated or calculated worth of an asset—such as a company, stock, currency, or product—derived through fundamental analysis. This value takes into account both tangible and intangible factors. Often referred to as the "real value," intrinsic value may differ from the current market price. Considering its associated risks, it represents the price a rational investor would be willing to pay for an investment.

Intrinsic Value Definition and Importance

Intrinsic value refers to an asset's true worth based on its fundamental characteristics, such as earnings, dividends, or future cash flows. It represents the actual value, independent of market conditions or speculation.

For investors, intrinsic value is important because it shows the true value of an investment, which is often different from its market price. Knowing this helps you figure out if something is too expensive or a good deal. By understanding the intrinsic value of a share, investors can make better decisions about whether to buy, sell, or hold on to an investment.

It also helps estimate the risks and potential rewards. However, before investing, it is important to do your research or talk to a financial advisor. 

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

How to Calculate Intrinsic Value?

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

Another method for calculating intrinsic value involves the use of financial metrics such as the Price-to-Earnings (P/E) ratio. To use this method, you 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)

The Dividend Discount Model (DDM) 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.

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.

Difference Between Market Value and Intrinsic Value

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

Risk Adjusting the Intrinsic Value

When figuring out how much a stock is worth, it is important to think about the risks that come with the investment. Adjusting for risk helps make sure the value is more accurate and reflects any problems the company might face. This way, investors don't end up thinking the stock is worth more than it is.

One way investors can adjust for risk is by raising the discount rate in the Discounted Cash Flow (DCF) model. This makes the stock’s future cash flow worth less today, showing that there's more risk.

Another way is to use a "margin of safety." This means investors only buy a stock if its current price is much lower than its true value. This extra cushion helps protect against mistakes in calculating the value and any unexpected problems, making the investment safer.

Conclusion
Analyzing the true value of shares is an important part of stock analysis and helps investors make better decisions. It allows them to estimate what a stock is worth, making it easier to decide when to buy or sell it.