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Benjamin Graham and Warren Buffett were fans, but what exactly is intrinsic value, what’s the formula for finding it, and why is it important to value investors?
In this article, we will explain how to calculate the intrinsic value of a share in the stock market, which can help investors to make a decision on which stock to trade, based on its valuation. Intrinsic value can be hard to determine, so why not open a risk-free demo account first to practise with virtual funds?
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Intrinsic value is how much a particular stock is worth based on how much a company makes on its assets, as well as other factors. Value investors may use an intrinsic value formula to determine whether a stock is overvalued or under-priced in the market.
The intrinsic value of a company is a theoretical concept. Different formulas are used to determine the ‘true value’ of a stock. This is the definition of intrinsic value, but true value will vary based on who is calculating it and what their assumptions are.
The market price of a stock may be quite different from its intrinsic value, which presents both an opportunity and a challenge. If the stock price is higher than the intrinsic value, it may be overpriced and not worth buying (but potentially worth shorting). If the stock is trading below its intrinsic value, it may be under-priced and may be worth going long on or purchasing.
Most investors and traders assume that the price of a stock will move towards its intrinsic value over time. However, more generally, the stock price is unlikely to stay at its intrinsic value for long. The stock price will generally oscillate around the intrinsic value. Therefore, traders and investor who use this concept may prefer to buy when the stock is trading below its intrinsic value, and then sell when it is above.
Buffett is one of the most well-known value investors, who learned from the ‘father of value investing’, Benjamin Graham. However, their approaches differ slightly. While Graham looked at what a company had already done in his analysis, Buffett looks at what a company could do in the future and factors this in as well. Buffett became an advocate of not just buying stocks for cheap but buying companies that are growing at a reasonable price. This is the underlying focus of his stock selection.
Value investing and intrinsic value fall under the broader category of fundamental analysis.
There are several methods for calculating intrinsic value. One way is no better than another, but rather, they utilise different criteria and, therefore, may come up with different valuations for the intrinsic value of a company. Some investors use one model, while other investors may use two or three to get a range of what the intrinsic value may be.
The most common valuation formula – the discounted cash flow model – adds up the forecasted cash flows of a company to determine value. The future cash flows are discounted using a required rate of return to determine the value of a company based on its ability to generate a cash position.
Let’s assume that Apple can grow its cash flows by an average 6% per year based on prior growth and the required rate of return is 4%.
The formula for calculating discounted cash flows is:
Intrinsic value = CF1 / (1 + r) + CF2 / (1 + r)^2 + CF3 / (1 + r)^3 + …
CF refers to cash flow in year one (CF1), year two (CF2), and so on.
Assume Apple’s most recent year’s cash flow was $80bn (rounded). This needs to be projected out into the future at the growth rate. A spreadsheet is recommended so that the cash flows can be added for up to 30 years or more.
The example below shows five years:
Year 1: $84.8bn
Year 2: $89.88bn
Year 3: $95.28bn
Year 4: $100.99bn
Year 5: $107.1bn
These are then discounted back. For Year 1, divide by 1.04. For Year 2, divide by 1.04 twice (1.04^2), for Year 3 divide by 1.04 three times (1.04^3), and so on.
Year 1 discounted: $81.53bn
Year 2 discounted: $83.10bn
Year 3 discounted: $84.70bn
Year 4 discounted: $86.33bn
Year 5 discounted: $89.99bn
Add all these discounted values up to get $425.65bn, but that is only for the next five years.
If we expect the company to be around for at least 40 years, we need to do this process for 40 years. In this case, this results in a value of $4,843.78tn.
With 16.5 billion shares outstanding, the implied value of the stock is $293.56. It is a major assumption to think a company can grow cash flows at 6% for 40 years. If using a spreadsheet, at any given year you can increase or decrease the assumed growth rate to change the intrinsic value.
The price to earnings model uses the price-earnings (PE) ratio, earnings per share (EPS), and growth rate, to assess the intrinsic value of a stock.
The formula for calculating a price to earnings model is:
EPS x (1 + r) x P/E
[EPS is the amount of earning over the last year.
r is expected growth rate of earnings.
P/E is the current P/E for the stock.]
Using Apple, if the company had $5.12 per share in earnings over the last 12 months, and earnings have been growing at 15% per year, and the P/E ratio is 29, then the intrinsic value is: $5.12 x (1 + 0.15) x 29 = $170.
This assumes that the P/E will remain the same, but the current P/E may be higher or lower compared to historic prices. You could look at the P/E the stock typically trades at and consider using that. For example, if a more common P/E is $20, this may be better to use. Then, the value is $117, providing quite a different perspective.
As the name implies, the method can only be used if the company being analysed issues regular dividends.
The formula for calculating a dividend discount is:
Stock value = Dividends / (cost of capital equity – dividend growth rate)
[Dividends are the dividends for next year, based on the dividend growth rate projection.
Cost of capital equity is how much investors want from an asset to hold it. It is based on the Capital Asset Pricing Model and is calculated as: [Risk free rate + Beta x (required return – risk free rate)]. For the example below, 1% was used as the risk-free rate, beta is 1.2, and required return is 5%, resulting in cost of capital equity of 5.8%.
Dividend growth rate is how much the dividends are expected to grow (percent) each year into perpetuity.]
Looking at Apple, let’s assume the last dividend was $0.81 for the year. Also, assume dividends increase by 5%, on average, going forward. The next year’s dividend is projected to be $0.81 x 1.05 = $0.85.
Apple value = $0.85 / (0.058 – 0.05) = $106.25
The cost of capital can affect this greatly. Using 9.5% instead of 5.8% drops the value of Apple to near $19. Therefore, these calculations are very sensitive to inputs that are already estimates.
This method sums up all the company’s assets, and then subtracts its total liabilities. It does not account for growth in the company.
Assume that Apple has $323bn in assets and $258bn in liabilities. Therefore, the company’s asset-based valuation is $65bn.
With 16.5 billion shares outstanding, based on this method, the company is worth $3.90 per share. This is not a great reflection of its worth because it doesn’t consider how much the company earns on those assets and liabilities.
This valuation method works better for companies that are in a liquation, because at that point, they are only worth what the assets can be sold for after covering liabilities.
While intrinsic value formulas make a lot of assumptions, they can help an investor determine if the price of a stock is too high or low. It provides a frame of reference for the current state of the stock through company analysis.
If a stock has an intrinsic value that’s higher than its market value, especially when based on several intrinsic value calculations, then it may present a buying opportunity. But before buying, consider whether the assumptions made in the calculations are reasonable.
Deep value stocks – companies trading well below their intrinsic value – may be mispriced for a reason, such as investors expecting trouble for the company ahead.
If a stock has an intrinsic value that is lower than its market value, it may be an opportunity to short sell the stock, since it may have limited upside. Be cautious with this. Stocks can stay mispriced for a long time, and there is no guarantee that others agree with the intrinsic value you have come up with.
Sometimes, whole industries or sectors of stocks will be undervalued. Thematic investing is a process of buying or trading on a collection of stocks that belong to a similar group, such as technology, robotics or finance.
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Markets are dynamic. The constantly changing make-up of companies and the prices they trade at presents both opportunities and dangers. As new information (such as earnings) arises, it presents opportunities for traders to take advantage of potential mispricing in the market. But it also means that prior calculations may become outdated quickly because growth rates, for example, can change with some regularity.
Who popularised value investing?
Benjamin Graham’s book, The Intelligent Investor, published in 1949, laid the foundation for value investing. Warren Buffett worked for Graham and then went on to become a successful investor himself. Learn about value investing.
What is deep value?
Deep value is a term for stocks that are trading at very cheap prices relative to intrinsic value or earnings. Stocks may trade at a deep value due to a market crash (where nearly every stock declines), or because the company is going through a difficult time, has bad publicity, or is in an industry few investors are currently interested in owning. Some may refer to these as undervalued stocks.
Is trading based on intrinsic value contrarian?
It can be. If a stock has sold off, it means others may not want it, but a value investor may view it as a good deal and buy it. When a stock price is very high, relative to intrinsic value, many people are loving the stock, yet a value investor may sell it because it is trading well above intrinsic value. This often happens with growth stocks, which are considered as opposing to value stocks.
How do you calculate the intrinsic value of options?
The intrinsic value of a call option is the current price of the stock minus the option’s strike price. The intrinsic value of a put option is the strike price minus the current price of the underlying stock.
Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.
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