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Have you ever wondered why a particular stock sells for say, Rs 250 while another for Rs 1000? Who decides these prices? That is what we will look at in this section – what is intrinsic value.
In the last section, we learnt about the various tools and techniques of technical analysis and how to use them. Now, let’s pause for a minute and contrast it with fundamental analysis before we go any further. This is where the concept of intrinsic value of stocks comes into play. It is, after all, the figure around which the entire process of technical analysis revolves.
Intrinsic value of a stock is its true value. This is calculated on the basis of the monetary benefit you expect to receive from it in the future. Let us put it this way – it is the maximum value at which you can buy the asset, without making a loss in the future when you sell it. Before you wonder how complicated this sounds, let us assure you we will look at this in detail further.
It is true that technical analysis helps you predict how the stock price is going to move and what price levels it may touch. However, the price is still very closely linked to the intrinsic value of the stock. So, technical analysis only helps determine the direction and the extent of the stock price movement.
For prices to move in a particular direction, they must first start from somewhere. Let’s say the price of a stock is Rs 150 right now. Your technical analysis suggests that it will go up to say, Rs 175. But where did the current price of Rs 150 come from? There is a method for calculating it.
Let’s understand with the example of a house you are buying. The key purpose of this apartment is for giving it out on rent. How much would you be willing to pay for it?
Suppose you want to hold it for ten years. You would probably not want to pay more for it than you can possibly earn from it. In other words, the total rent earned in 10 years, plus, the price you may receive upon selling it after ten years. The value so calculated would be the intrinsic value of the flat.
For accuracy, this value is adjusted for factors such as inflation and various kinds of risks. We will see this later in the section. This method of calculating intrinsic value is called the discounted cash flow model or the present value model. It can also be used for calculating the intrinsic value of a stock.
So the conclusion: the intrinsic value of a stock is the total amount that you might earn from it in the future.
It is generally calculated in two ways—the present value method and the relative value method.
We just saw how intrinsic value of a residential apartment can be calculated using its expected future income. A similar approach can also be adopted for equity shares. The question that arises then is—what is the expected future income in case of shares? When you invest in stocks, the company offers you a share in its annual income. This is called a dividend. Also, just as in case of the apartment, you receive a sum of money upon selling your share. If you can add up the value of the dividends and the future selling price (called terminal value) of the share, you will get the intrinsic value of your share.
However, there is one caveat. Does a dividend of Rs 100 paid to you today have the same value as Rs 100 paid to you after 10 years? Probably not! Rs 100 received after ten years has lower value than the same amount received today. In other words, money loses value with time because of inflation. Think about it; can you buy the same amount of goods and services for say Rs 1,000 today as you did five years back? No, right? This is called the time value of money.
To adjust for this change in value, you will have to put each future dividend through a process called discounting. As part of this process, you will divide each of the future dividends by a specific rate, before adding them all together. The values, thus obtained, are added to obtain the intrinsic value. Here are the steps involved in the estimation of present value:
Alternatively, you can also use this approach to calculate the intrinsic value of a company’s stock. Rearranging the formula for PE, the intrinsic value of the stock is the product of PE and EPS. Now, if you use the competitors’ average PE of 23 and multiply it by your company’s EPS of 5, you will get the intrinsic value of your stock. It will work out to Rs 115. This means that the fair price to pay for your stock is Rs 115. Since you are getting it in the market for Rs 100, it is a steal! You can buy it and expect it to appreciate to this fair value.
The importance of the relative value approach lies in the fact that it uses both, the company’s own fundamentals as well as market trends to calculate the intrinsic value of a stock. This makes it more realistic, but prone to flaws. If fundamentals change dramatically in the future, your intrinsic value estimate can be proven false.
Now, let us come to the second method for calculating the intrinsic value of stocks. This involves the comparison of the price of the stock with one of the company’s fundamentals.
If you remember from our fundamental analysis chapters, a fundamental is an important financial figure of the company drawn from its financial statements. Some key fundamentals are sales revenue, net income or profit (also called earnings), book value of equity shares etc. When you buy the shares of a company, you essentially own a portion of these fundamentals. For example, you earn a portion of the company’s sales revenues or profits. This is because owning shares makes you a partial owner of the company.
Now, logically, you always try to buy at a bargain by paying the least possible amount. The lower the market price of these shares, the less you have to effectively pay for buying each unit of these fundamentals.
Let’s look at an example. One of the ratios you can use for relative value analysis is the price to earnings (PE) ratio. In this ratio, you compare the per share price of the company with its per share earnings. If the price per share is Rs 100 and its earnings per share (EPS) is Rs 5, the PE will work out 20. This means that for each rupee of the company’s earnings you are paying Rs 20.
Now, how do you know if this price is fair? To find this, you must compare it with the PEs of the company’s competitors. If the average PE of the competitors is say, 23, you are getting your shares for cheaper. This is because, for a share of one of the competitors, you will have to pay on average Rs 23 per unit of earnings. For your company, though, you only pay Rs 20. This is why this approach is called the relative value approach.
We have discussed the virtues of intrinsic value and fundamental analysis at great length. Now, let’s play the devil’s advocate.
Despite its many advantages, technical analysts reject the concept of intrinsic value. Followers of the technical approach believe that future market trends can be predicted accurately only by analysing past price movements. Intrinsic value-based investing is
Intrinsic value is calculated based on a company’s fundamentals as of today. Future fundamentals are an estimate based on your own calculations. It is, thus, a hypothetical figure. This is not dependable. Events in the future may change these fundamentals significantly.
For example, if the economy turns up, or if a company acquires another company, its sales may increase dramatically. This will lead to an increase in its intrinsic value. However, these possibilities cannot be factored into intrinsic value calculations in advance. Technical analysis, in contrast, is more adept at predicting them.
The last flaw of the intrinsic value approach is that it cannot be used for all asset classes. In case of stocks, there are fundamentals such as future dividends, sales revenue and earnings. So the intrinsic value approach can be used. However, markets also trade in assets such as commodities, metals and currencies.
How can you estimate fundamentals for these? For example, if you invest in gold, how can you estimate its future earnings or future dividends? Gold is not a company. It neither earns income nor pays dividends. In such cases, only technical analysis can be used for estimating value.
Another flaw of fundamental analysis is that prices may not appreciate enough to equal intrinsic value in the future. For example, in our earlier illustration, we assumed that the stock is currently priced at Rs 100. Your relative value analysis suggested that it could appreciate to Rs 115.
However, this will only happen if other investors in the market think like you. Only then will they all invest in the stock and make its price go up. However, other investors may not always think like you. This is particularly true of stocks of smaller companies, which are considered too risky to invest in. So, despite a lot of potential, these stocks may never go up.
This will keep you from making money, even though your analysis is perfectly accurate. Technical analysis is free from this flaw. This is because it is based on an analysis of historical market trends and stock demand-supply patterns. These are more realistic.
In the next section, we will continue our exploration of technical analysis. We will take a closer look at market trends and patterns that define the technical approach. click here.