What is Intrinsic Value of Share or Stock?

• 0
• 29 Nov 2023

Key Highlights

• Discounted cash flow analysis is commonly used to calculate intrinsic value.

• Value investors rely on this concept to find undervalued investment opportunities.

• In options trading, intrinsic value is determined by the difference between an asset's market price and the strike price of an option.

Intrinsic value is the expected or calculated value of a business, stock, money, or product that is determined through fundamental analysis. It encompasses realistic and abstract components and may or may not align with the current market value. Intrinsic value is also known as the amount of money that a rational investor would be willing to invest in an asset, considering the associated risks.

If you are considering investing in options, knowing how to calculate the intrinsic value is important. Unlike other financial assets, the value of options is based on concrete figures and metrics, so there is no need to estimate any value to determine the intrinsic value. The formula for calculating the intrinsic value of an option is as follows:

Intrinsic value = (Stock price - Option strike price) x (Number of options)

To better understand this formula, let's take an example. Suppose a stock is trading at ₹500 per share, and four call options are available for purchase, each call option allowing you to buy 100 shares at ₹450 per share. In this case, you can calculate the intrinsic value of each share as follows:

(₹500- ₹450) x 50 = ₹2550

Adjusting the intrinsic value to account for risk

Assessing the risk of adjusting cash flow is not an exact science, as it involves subjective interpretation and quantitative analysis. There are primarily two methods for this assessment - which are as follows:

• Discount Rate method

In the discount rate method, the analyst usually considers a company's weighted average cost of capital, which includes a risk-free rate (determined from the government bond yield), a premium based on the stock's volatility, and an equity risk premium. The underlying principle is that a more volatile stock is riskier, and an investor should get better returns. Hence, a higher discount rate is used in such situations, which reduces the expected future cash flow value.

• Factor of Confidence

In the discount rate method, the analyst usually considers a company's weighted average cost of capital, which includes a risk-free rate (determined from the government bond yield), a premium based on the stock's volatility, and an equity risk premium. The underlying principle is that a more volatile stock is riskier, and an investor should get better returns. Hence, a higher discount rate is used in such situations, which reduces the expected future cash flow value.

• Obstacles of an Intrinsic Value

Valuing assets using the intrinsic computing method is complex. This method requires many assumptions to project cash flow, making it sensitive to changes in these assumptions.

Another challenge in this method is that different investors may calculate the weighted average cost of capital differently. This includes factors such as beta and market risk premium. Additionally, the use of subjective probability factors can further complicate the process.

The future is uncertain, and this can lead to different investors arriving at varying values for the same asset using the intrinsic computing method. Everyone has a different outlook on the future, making determining which valuation is correct is impossible.

Technical analysts do not consider intrinsic value and use past price movements to predict future market trends. They believe this approach is the most accurate way to anticipate the future of the market. Let’s have a look at some of the other methods.

• Intrinsic value fluctuation

Technical analysts argue that intrinsic value may be unstable, as it is calculated based on a company's current fundamentals, and future fundamentals are estimated based on calculations, which may not be dependable. Future events, such as an economic upturn or a company acquisition, can dramatically change these fundamentals, significantly increasing intrinsic value. However, these possibilities cannot be factored into intrinsic value calculations in advance, making technical analysis a more capable approach for predicting such events.

• Exploring the flaw in fundamental analysis

Fundamental analysis has a flaw. In fundamental analysis, the market value of a stock may not increase enough to match its intrinsic value. For example, suppose a stock is currently priced at ₹100 and your relative value analysis suggests that it could appreciate to ₹115. In that case, it will only happen if other investors in the market agree with your analysis and invest in the stock. However, this may not always be the case, especially for smaller companies that are considered too risky to invest in. As a result, despite having a lot of potential, these stocks may never increase in value, causing you to lose money even though your analysis is accurate. Technical analysis, on the other hand, is based on historical market trends and stock demand-supply patterns, making it more realistic and free from this flaw.

• Intrinsic value analysis is not viable for all asset types

The intrinsic value approach is not a one-size-fits-all solution for asset valuation. Although it is appropriate for stocks, it falls short when it comes to commodities, metals, and currencies. These assets lack fundamentals such as earnings and dividends, making it impossible to determine intrinsic value. Technical analysis, on the other hand, is an effective alternative for estimating value in these cases. By relying on technical indicators and market trends, it is possible to gain valuable insights into the future performance of these assets.

Industry professionals use valuation methodologies to appraise a company’s worth as a going concern, and three primary techniques are commonly used for this purpose.

1. Comparable company analysis:

This method is called trading multiples or peer group analysis. It uses relative valuation and compares the company under review to similar firms by examining trading multiples such as P/E or EV/EBITDA ratios. By analysing these ratios, analysts can gain valuable insight into the company's value based on market comparables.

1. Precedent transactions:

This method compares the target company to others in the same industry that were recently sold or acquired. It helps to understand the target company's value, similar to relative valuation. This analysis offers valuable insights into the target company's valuation and can be used to make informed decisions.

1. Discounted cash flow analysis:

DCF Analysis is a popular method for intrinsic valuation. Analysts predict future cash flows, discounting them to present value using WAC. For example, a company with an initial five-year cash flow of ₹100 per annum, 10% discount rate, and 5% terminal growth rate can be evaluated using DCF Analysis.

The value of the cash flow in 2019 is ₹91. The value of the terminal is ₹2100, calculated by perpetual growth. The specific method discounts the terminal value to its present value.

Conclusion

Intrinsic value is a crucial factor in investment decision-making, especially for value investors. It represents the true worth of an asset based on quantitative and qualitative factors. Although discounted cash flow analysis is common, it faces challenges like subjective interpretations and uncertain future projections. Understanding intrinsic value provides valuable insights into investment opportunities and helps investors make informed decisions amidst market uncertainties

Intrinsic value is essential in determining an asset's worth, which helps make investment decisions based on its fundamental value rather than market fluctuations.

It is worth noting that intrinsic value can change over time due to shifts in market conditions, company performance, or economic factors influencing asset valuations.

Tools and software, such as financial models and valuation techniques, can help determine intrinsic value by analysing company fundamentals and market data.

Suppose an asset's intrinsic value exceeds its market price. In that case, it suggests that the asset may be undervalued, which presents an opportunity for investors seeking assets trading below their actual worth.

It is essential to understand that money lacks intrinsic value. Its worth is derived from societal consensus and governmental backing rather than inherent utility or physical properties.