Intrinsic Value of Stock | Definition, Formula & Example

What Is Intrinsic Value?

Intrinsic value is the estimated true worth of a company or an asset based on their basic characteristics, without regard to the current market price. The intrinsic value meaning encompasses the "real" value of a company as identified by a determined analysis of its prospects and financial performance and assets rather than its price in the market, which can change from day to day based on trading.

Put differently, the intrinsic value of stock is the price a rational investor would decide it is worth to buy an investment based on risk. Intrinsic value is the cornerstone of value investing, a strategy popularized by investors such as Warren Buffett and Benjamin Graham.

The fundamental difference of the two concepts is that intrinsic value looks at what a company is worth based on its various cash flows and normal profits over time, while market price represents what investors are willing to pay in the moment, and based on emotion, speculation, or conditions in the market.

How Intrinsic Value Works

Intrinsic value is built on the idea that each asset has an underlying value that can be determined using fundamental analysis. This consists of looking at qualitative and quantitative characteristics which embrace the long-term value of a company. 

Qualitative characteristics are the company's business model, quality of management, competitive advantages (economic moat), position in the industry, and market circumstances. On the other hand, quantitative characteristics refer to financial figures such as financial statements, cash flows, growth of earnings, debt levels, and other various financial ratios. 

The theory is, stock prices can be very volatile in the short term and driven by market sentiment dictated by fear, greed, and speculation, but will move to its underlying value over a longer time frame. Warren Buffett paraphrased Benjamin Graham best: "In the short run, the market is a voting machine, but in the long run, it is a weighing machine."

This convergence creates investment opportunities when stocks trade significantly above or below their calculated intrinsic value of share:

• Stock trading below intrinsic value = Potentially undervalued (buying opportunity)

• Stock trading above intrinsic value = Potentially overvalued (avoid or sell)

• Stock trading near intrinsic value = Fairly priced

How to Calculate Intrinsic Value

There are several established methods to calculate intrinsic value, each with its own strengths and appropriate use cases. Understanding how to calculate intrinsic value of share requires familiarity with the most commonly used approaches:

1. Discounted Cash Flow (DCF) Method

The DCF method is considered the gold standard for calculating intrinsic value. This approach estimates the present value of all future cash flows a company will generate.

Formula:

Intrinsic Value = Σ [CFt ÷ (1 + r)^t] + Terminal Value

Where:

• CFt = Cash flow in year t

• r = Discount rate (usually WACC - Weighted Average Cost of Capital)

• t = Time period

• Terminal Value = Value of cash flows beyond the forecast period

Example DCF Calculation: Let's say a company generates ₹100 crore in annual cash flow, expected to grow at 5% annually for 5 years, with a 10% discount rate:

• Year 1 Present Value: ₹100 ÷ (1.10)¹ = ₹91 crore

• Year 2 Present Value: ₹105 ÷ (1.10)² = ₹87 crore

• Year 3 Present Value: ₹110 ÷ (1.10)³ = ₹83 crore

• Terminal Value: ₹115 × 1.05 ÷ (0.10 - 0.05) = ₹2,415 crore

• Present Value of Terminal Value: ₹2,415 ÷ (1.10)⁵ = ₹1,500 crore

Total Intrinsic Value = Sum of all present values = ₹1,761 crore

2. Dividend Discount Model (DDM)

The DDM is ideal for companies that pay regular dividends. It calculates intrinsic value of stock based on expected future dividend payments.

Formula:

Intrinsic Value = D₁ ÷ (r - g)

Where:

• D₁ = Expected dividend next year

• r = Required rate of return (cost of equity)

• g = Dividend growth rate

Example DDM Calculation: If a company pays ₹20 per share dividend, expected to grow at 3% annually, with a 8% required return:

Intrinsic Value per Share = ₹20 × 1.03 ÷ (0.08 - 0.03) = ₹412 per share

3. Earnings-Based Valuation

This method uses the company's earnings per share (EPS) and growth expectations.

Formula:

Intrinsic Value = EPS × (1 + r) × P/E Ratio

Where r = expected growth rate of earnings

4. Asset-Based Valuation

This approach calculates value based on the company's net assets.

Formula:

Intrinsic Value = Total Assets - Total Liabilities

This method works well for asset-heavy companies but doesn't account for growth potential or earning capacity.

5. Benjamin Graham Formula

The legendary value investor developed a specific formula for growth stocks:

Modern Version:

Intrinsic Value = EPS × (8.5 + 2g) × 4.4 ÷ Y

Where:

• EPS = Earnings per share

• g = Expected annual growth rate

• Y = Current yield on AAA corporate bonds

Market Risk and Intrinsic Value

Market risk significantly impacts the relationship between intrinsic value and stock prices. Understanding this relationship is crucial for making informed investment decisions.

Key Risk Factors:

1. Volatility Risk: Highly volatile stocks carry a greater level of uncertainty relating to DCF calculations, which can require higher discount rates, which leads to a lower calculated intrinsic value. 

2. Economic Risk: Macroeconomic factors such as interest rates, inflation, and business cycles can impact not only the discount rate but also projected cash flows. 

3. Industry Risk: Longer-term cash flow-powered valuation projections will have risks associated with the industry-specific risks, winded advances in technology, and/or changes in regulations that may impact the industry in the future. 

4. Company-Specific Risk: Factors associated with the leadership quality, competitive position, debt levels, and overall sustainability of the business model can dramatically impact the calculation of intrinsic value.

Risk Adjustment Methods:

Method 1: Risk-Adjusted Discount Rate
Use higher discount rates for riskier companies. For example:

• Low-risk utility company: 8% discount rate

• High-risk technology startup: 15% discount rate

Method 2: Probability-Weighted Cash Flows
Assign probability factors to projected cash flows:

• Stable company cash flows: 90% probability

• Speculative company cash flows: 50% probability

Intrinsic Value of Options Contracts

In options trading, intrinsic value has a specific, measurable meaning. It represents the immediate exercisable value of an option contract.

For Call Options:

• Intrinsic value exists only when the stock price is above the strike price

• Formula: Stock Price - Strike Price (if positive, otherwise zero)

For Put Options:

• Intrinsic value exists only when the stock price is below the strike price

• Formula: Strike Price - Stock Price (if positive, otherwise zero)

Important Rules:

• Intrinsic value can never be negative - it's either zero or positive

• Only in-the-money (ITM) options have intrinsic value

• Out-of-the-money (OTM) options have zero intrinsic value

Example of an Option's Intrinsic Value

Let's examine practical examples to understand how options intrinsic value works:

Call Option Example:

Scenario: Reliance Industries stock trading at ₹2,500

• Call option with ₹2,400 strike price:

Intrinsic Value = ₹2,500 - ₹2,400 = ₹100 This option is in-the-money (ITM) with ₹100 intrinsic value

• Call option with ₹2,600 strike price:

Intrinsic Value = ₹2,500 - ₹2,600 = ₹0 (cannot be negative) This option is out-of-the-money (OTM) with zero intrinsic value

Put Option Example:

Scenario: HDFC Bank stock trading at ₹1,400

• Put option with ₹1,500 strike price:

Intrinsic Value = ₹1,500 - ₹1,400 = ₹100

This option is in-the-money (ITM) with ₹100 intrinsic value

• Put option with ₹1,300 strike price:

Intrinsic Value = ₹1,300 - ₹1,400 = ₹0 (cannot be negative) This option is out-of-the-money (OTM) with zero intrinsic value

Important Note: The total option price consists of intrinsic value plus time value (extrinsic value). As expiration approaches, time value decreases toward zero, leaving only intrinsic value.

Why Is It Useful to Know Intrinsic Value?

Understanding the intrinsic value meaning and how to apply it provides several critical advantages for investors:

1. Investment Decision Making

Intrinsic value is an objective standard that can help you evaluate whether to buy, hold, or sell a stock. This standard removes emotional decision-making, so you can base your decisions on rational data-driven foundations, as outlined above in Chapter 4. 

2. Identifying Market Opportunities

Value investing opportunities arise when:

• Market price < Intrinsic value = Potential buying opportunity

• Market price > Intrinsic value = Potential overvaluation (avoid/sell)

3. Risk Management

Understanding a company's intrinsic value of stock allows you to assess the margin of safety - the difference between intrinsic value and the market price. Warren Buffett, a noted value investor, maintains a minimum margin of safety of at least 30% before making an investment decision.

4. Long-term Investment Strategy

Focusing on intrinsic value investing supports a long-term investment approach, preventing you from getting caught up in short-term volatility of the stock market. This has been successful long-term investing strategy utilized by famous investors Warren Buffett and Benjamin Graham.

5. Portfolio Construction

Understanding intrinsic value helps you construct a diversified portfolio of companies and identify possible undervalued companies that hold strong fundamentals, reducing risk in your overall portfolio.

What's the Difference Between Market Value and Intrinsic Value?

The distinction between market value and intrinsic value is fundamental to successful investing:

Key Differences Explained:

Market Value is the amount investors are willing to buy the asset for now, based on sentiment and emotions that are driving the price right now based on the news and market. Market Value is very visible, and it dynamically changes throughout trading hours. 

Intrinsic Value is the actual worth of the company based on its fundamental capacity to generate cash flows, profits and returns over time. Intrinsic Value requires an examination of the company’s financials but will provide a more consistent measurement of actual worth.

Market Inefficiencies Create Opportunities:

The gap between these two values creates investment opportunities. Successful value investors profit by:

• Buying when market value < intrinsic value (undervalued stocks)

• Avoiding or selling when market value > intrinsic value (overvalued stocks)

Is Intrinsic Value Better Than Market Value for Investing?

For long-term investing, understanding how to calculate intrinsic value of share is generally superior to relying solely on market value as an investment guide. Here's why:

1. Advantages of Using Intrinsic Value

1. Objective Analysis Intrinsic value is based on factual information and financial statistics, rather than human emotions, wise investors can invest based on a logic researched in the numbers.

2. Long-term Focus Stock prices can swing wildly in the short term, but intrinsic value allows us to focus on the long-term business story and overall wealth focus.

3. Risk Reduction
Investing in stocks trading at less than intrinsic value puts a margin of untouched value into the investment and reduced downside risk.

4. Proven Success
There is not a better case study than Warren Buffett's time-tested success.  By focusing on acquiring wonderful businesses at fair prices (calibrated on intrinsic value) his fund has produced stunning long-term results.

2.When Market Value Might Be Preferred

1. Short-term Trading
A daily trader and short-term speculator may be more interested in market price and technical analysis than intrinsic valuations. 

2. Market Timing
Active traders looking to capture short-term price action, as an example, will rely more on market sentiment and momentum, not fundamental intrinsic value, when constructing a trade.

3. Best Approach: Combined Strategy

The best investment strategy is usually a combination of these two ideas: 

• To select investments and create a long-term plan, rely on intrinsic value.

• Use market value to determine when to buy or sell stock.

• Be aware of the difference between the two in order to identify trade opportunities.

 

Key Takeaway: The intrinsic value of stock is a better indicator of long-term wealth building through stock investing because it is oriented towards the fundamental drivers of business success and is less subject to short-term market noise. However, knowing both concepts can help investors make better decisions and take advantage of stock market inefficiencies.

Conclusion

To invest intelligently and build wealth over time, it's important to understand and calculate the intrinsic value of share. Rather than relying on short-term hype or panics created by news or videos, investors should focus on a stock's fundamental value and its place in today's price. This will uncover undervalued opportunities to purchase and avoid overpaying for stocks - especially of businesses you want to own to allow value to grow over time.

Different types of calculations will yield different views of what the true value of a company is ranging from discounted cash flow (DFC) analysis or a dividend discount model. There is obviously broad uncertainty in these calculations so, there is no perfect method to calculating intrinsic value. Combined methods with reasonably conservative and optimistic projections work to create a better adjusted valuation method. 

Remember that intrinsic value investing teaches patience, discipline, and lifelong learning. Intrinsic value investing has worked for historical figures of success such as Warren Buffett who focused on purchasing great businesses for a reasonable value.

Above all, remember to manage your margin of safety when investing. This is the difference between the intrinsic value and market price of a business and protects "the investor" from errors in their estimation process or market movements that may or may not be correlated. Organic investing is difficult because it requires rational thinking, market analysis, and historical studies but will eventually leverage from a speculative process into a systematic process that looks for the creation of worth for investment purposes.

Disclaimer: This analysis is for educational purposes and not financial advice. Please consult a financial advisor before making investment decisions.

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