Intrinsic Value Of Stocks

You may have learnt about 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.

What Is Intrinsic Value?

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.

Intrinsic Value

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.

How Is Intrinsic Value Of Stocks Calculated?

Intrinsic value of a stock is measured on the basis of its present performance and financial health. There are different methods to calculate the intrinsic value of stocks. Here are some of the standard approaches often used.

Present Value Method:

• This method focuses on calculating the present value of projected cash flows that the asset under valuation will produce in the future.
• The basic tenet is that an asset's current value is defined by the present value of the predicted future cash flows.
• A good illustration of the present value technique is the discounted cash flow (DCF) analysis. Using a suitable discount rate, DCF includes forecasting future cash flows and discounting them to their present value.
• This discount rate normally takes into account both the investment's risk and the time value of money. The discounted cash flows added together give a ballpark figure for the asset's intrinsic value.

Relative Value Method:

• This strategy compares the asset's valuation to that of comparable assets or market benchmarks.
• It presumes that the asset's worth may be determined by taking into account how it compares to similar assets.
• Comparable Company Analysis (CCA) and Comparable Transaction Analysis (CTA) are two frequently used techniques under the relative value approach.
• The relative value technique is significant because it determines a stock's intrinsic worth using both market movements and the company's own fundamentals.

Risk Adjusting the Intrinsic Value

One can account for potential downward changes with cash flow fluctuations by risk-adjusting intrinsic value. This aspect of computations is highly arbitrary and combines elements of art and science. The two approaches to take into consideration volatility and potential fluctuations are as follows:

Rate of Discount: The analyst will often utilise the company's weighted average cost of capital (WACC) when using the discount rate technique. The WACC formula consists of a risk-free rate (often the return on a government bond) plus a premium calculated by multiplying the equity risk premium by the stock volatility premium.

This tactic is supported by the notion that increased volatility indicates a stock is a riskier investment. A shareholder might anticipate larger returns as well. The predicted future cash flow value is thus decreased when a larger discount rate is used.

Factor of Certainty: This method requires you to give each cash flow a certainty factor. To discount the investment, multiply it by the whole Net Present Value (NPV). As a result, this tactic lowers the investment cost. This strategy uses the risk-free rate as the discount rate since the cash flows are risk-adjusted. The yield rate and discount rate are therefore equal.

For example, the cash flow from a government bond is completely predictable. The discount rate is thus 7%. Similar to this, there is a 50% chance that a high-growth firm will have cash flow. Since the probability number already accounts for the risk associated with the high-risk organization, the same discount rate may be used.

Why Intrinsic Value Is Not Preferred In Technical Analysis

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

Challenges of Intrinsic Value

Investors should be aware of the following difficulties when determining a stock's intrinsic value before utilizing it:

• Calculating a stock's intrinsic value is a highly individualized process. The investor must make several assumptions when predicting a company's cash flows. Therefore, due to changes in the underlying assumptions, the net present value might fluctuate significantly.

• Similar to this, elements like beta, market risk premium, etc. must be evaluated independently when determining the weighted average cost of capital (WACC). As a result, the probability factor you employ in your computations is likewise quite arbitrary.

• It is extremely difficult to forecast the future. As a result, many investors arrive at various valuations for the same business or asset. This distinction results from the fact that each person's viewpoint on predictions is unique. Furthermore, there is no one technique to calculate intrinsic value accurately.

To sum up, intrinsic value is essential in figuring out the stock's value for investments. Since there are several methods for determining a stock's true worth, you must choose one based on the industry in which the firm operates and after taking into account its particular qualities.

Method of Valuation

An essential component of financial research and investment decision-making is the valuation of intrinsic value. The real value of an asset, often the stock of a firm, is represented by its intrinsic value, which is different from its market price. To assess intrinsic value, a variety of techniques are used, each with its own set of computations and presumptions. Let's examine the various methods for determining a share's intrinsic value.

Analysis of Discounted Cash Flows The most popular technique for determining a share's intrinsic value is the discounted cash flow analysis. Additionally called the DCF analysis. When utilizing this approach to determine the intrinsic value, you must carry out three straightforward steps:

• Determine the company's projected cash flow before investing in its stock.
• Now figure out the present value of each and every anticipated future cash flow.
• To get the intrinsic value of the share, add up all of these present values.

It might be difficult to predict the company's future cash flow. To calculate future cash flows, you must examine the company's financial accounts. Additionally, reading editorials and news items will be necessary to comprehend the expansion of the organization.

Based on a Financial Metric Analysis An analysis based on a financial measure is a common method of determining the intrinsic value of a share. To determine the intrinsic value of the share, one can utilise well-known ratios like the price-to-earnings ratio, etc.

Valuation Based on Assets The asset-based valuation approach may also be used to determine the intrinsic value of a share. Because it does not need intricate calculations of the future and current values of the company's cash flow, new investors choose this strategy. This method's formula is as follows:

Intrinsic value is calculated as follows: (Total tangible and intangible assets of a firm) - Total liabilities of a company.

Discount models for dividends The cash component is taken into account by several methods when determining an asset's intrinsic value. The dividend discount model, often known as the DDM, is one of the most widely used approaches by analysts to determine the intrinsic value of the company. Using this approach, the intrinsic value is determined using the following formula:

The Stock's Value is equal to EDPS / (CCE -DGR).

Where: Expected Dividend per Share (EDPS), Cost of Capital Equity (CCE), and Dividend Growth Rate (DGR) are acronyms for financial terms.

Intrinsic Value May Be Unstable:

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.

Intrinsic Value Estimation Is Not Possible For All Assets Classes:

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.

Market Value May Not Approach Intrinsic Value Sometimes:

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.

Conclusion

Looking at the intrinsic value of a share might help you better understand the financial returns of a business. In other words, it represents a share's actual value. Understanding the use cases for computing the intrinsic value is essential if you are an active investor. Depending on the values that are accessible to you, you can employ any of the strategies that were explained above. When analyzing the performance of the company, keep in mind that market value and intrinsic value are not the same.

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