The intrinsic value is the perceived value of an asset calculated using various fundamental analysis methods. That means that intrinsic value can be subjective. It's the belief that the market has not reached or discovered the true value of a stock.
Let's take a deep dive into the compelling topic of what is the intrinsic value of a stock. We'll review how to calculate intrinsic value of a stock and use it for your investments and trades.
Intrinsic value definition
The intrinsic value is the perceived value of a stock. This is not necessarily the market value, based solely on the price of its last trade. The intrinsic value is subjective and based on your calculation methods and what you include (i.e., intangible factors). It represents a holistic company evaluation, including tangible and intangible assets. Two different investors can have two completely different intrinsic values for the same stock.
The intrinsic value can be used as a reference figure to compare the current market value of a stock to determine if it is overvalued or undervalued. Remember that you can and should adjust the intrinsic value of stock when you receive new and updated information like earnings reports and forward guidance.
What does the intrinsic value tell you?
Intrinsic value can tell me many things about a stock. Of course, it depends on how you calculate intrinsic value and its proximity to its market price. When an intrinsic value is much lower than the market value current price, you may consider trimming down your position, ignoring the stock as a long candidate or even considering short selling the stock. If an intrinsic value is much higher than the market value, the stock is worth further analyzing as a candidate for investment.
Intrinsic value enables you to quantify your upside and downside as a percentage of that upside. It can be used as a baseline price to begin your analysis utilizing many more methods. It's also prudent to run an intrinsic value calculation for a company's peers and competitor stocks to gauge the variance between intrinsic and market value. This calculation can help you find potentially undervalued and overvalued stocks more accurately than the industry. In other words, comparing intrinsic values across a sector is like comparing apples to apples instead of apples and oranges.
How to calculate the intrinsic value of a stock
There are many ways to calculate a stock's intrinsic value. This is part of what makes intrinsic value subjective because your method will impact valuation. All the types of methods utilize fundamental analysis, which comprises financials, tangibles and even intangibles. Tangibles have straightforward values. These include cash, investments, real estate, property, equipment, machinery, inventory and receivables. Blue chip, large-cap and dividend stocks can be easier to calculate intrinsic value due to the availability of information as opposed to small-cap and penny stocks.
Intangibles can be very subjective as they don't have clear and straightforward valuations like equipment. Intangible helps to generate tangibles like revenues and cash flows. Intangibles can include a brand's reputation, customer loyalty, brand equity, human equity, the quality of the management team and even company culture. Intellectual property (IP) is technically categorized as intangible, but assessing a valuation based on comparables and royalties can be easier. IP can include patents, copyrights, trademarks and industrial designs. It's also beneficial to compare your intrinsic value with experts and analysts to gauge the range of valuations. Calculating intrinsic value can be complicated or simple. You can also use an intrinsic value calculator to assist you.
How to use intrinsic value to pick the right stock
The first step in using intrinsic value to pick stocks is by making a calculation. Here are various methods that investors can use to answer the question of how to find the intrinsic value of a stock. You can perform these calculations if you can access fundamental data like balance sheets, income statements, dividend history, financial metrics and earnings reports, estimates and guidance.
Discounted cash flow (DCF) method
This method is the most common when calculating the intrinsic value of a stock. It helps to determine what price a stock should be trading at. The discounted cash flow method tries to determine the present value of the future cash flows after accounting for the time value of money. The method estimates a company's future cash flows and discounts them to the present using a discount rate. It is highly sensitive to the assumptions made of the forecast of future cash flow, which is more of a prediction. You must forecast future cash flows by making projections based on historical cash flows and growth rates.
It uses free cash flow (FCF), calculated by subtracting capital expenditures from operating cash flow. The discounted rate is the cost of capital used to discount future cash flows back to the present. The weighted average cost of capital (WACC) considers the cost of equity, debt and capital structure to gauge and average expected return. To calculate the discounted future cash flows to present value (PV), divide the FCF by 1 plus the discount rate squared by the number of years. Discount the terminal value back to present value using the discount rate and add up the PVs of projected cash flows and the discounted terminal value to estimate the total intrinsic value of the company. Intrinsic value per share is calculated by dividing the total intrinsic value of the company by the number of outstanding shares.
P/E ratio method
This method is also called the earning multiplier model. It is a more straightforward method that calculates intrinsic value by multiplying the stock's price-earnings (P/E) by its expected future earnings. You can estimate the intrinsic value by comparing a stock's P/E to its historical average or industry peers.
Dividend discount model (DDM)
Similar to the DCF method applicable to dividend-paying companies. It tries to estimate the present value of expected future dividends.
Gordon Growth Model (GGM)
This method calculates the terminal value, which accounts for all cash flows beyond the projection period. The Gordon Growth Model calculated terminal value by dividing the last projected year's FCF multiplied by 1 plus the perpetual growth rate divided by the discount rate minus the perpetual growth rate. GGM is also a DDM and assumes dividends will grow indefinitely at a constant rate.
Book value
Many investors use the book value as a floor price for intrinsic value. The book value is calculated by subtracting the total liabilities from the total assets and dividing that number by the total outstanding shares. Book value doesn't consider future earnings, cash flows or growth.
Example of an intrinsic value calculation
Let's use the discounted cash flow (DCF) method to determine the intrinsic value of e-commerce giant eBay Inc. NASDAQ: EBAY. EBAY was trading at $43.43 on the market close on September 10, 2023.
We have to make many assumptions before calculating intrinsic value. We assume eBay will grow at 5% after 2027 in perpetuity for a terminal value of $100 billion. We will use a 10% discount rate. The cost of capital is 12%. The growth range assumption is 10% in 2023, 8% in 2024, 6% in 2025 and 4% in 2026 and beyond. Its operating margin is 20% for 2023, 24% in 2025, 26% in 2026 and beyond. The time horizon is five years. We will assume eBay has no debt.
We take the assumptions as mentioned earlier and apply the formula for intrinsic value:
Intrinsic Value = (Future Cash Flows / (1 + Discount Rate) ^ n) + Terminal Value
N is the time horizon.
The intrinsic value of EBAY is $69.41 per share.
As you can see, the current price of EBAY at the time of the calculation was $43.43. That is a $24.48 discount to its current market value. Based on the calculations, EBAY is trading at a 36.5% discount to its intrinsic value. EBAY would have a 57.5% upside if it were to reach its intrinsic value. We could limit our risk by attaching a 20% stop loss to the position. This makes for a greater than two-for-one reward-to-risk ratio. This would make EBAY an undervalued stock and an attractive candidate to add to the portfolio for a very nice risk reward of risking a 20% loss to gain a 57.5% profit.
Intrinsic value for call and put options
When it comes to options contracts, the intrinsic value meaning is different than with stocks. Call and put options contract prices comprise the premium and the intrinsic value. With options, intrinsic value is not subjective. It is a straightforward value when an option trades "in the money." You can calculate the intrinsic value of an option by subtracting the contract's strike price from the stock's current price. For example, if you have an XYZ call option with a $50 strike price and the stock trades at $52, then the intrinsic value is $2.
This means the option's intrinsic value is worth $2 because if you exercised the call option at $50, it would still leave you with a $2 profit. However, if the stock traded at $48, your $50 call option would be "out of the money" with a $0 intrinsic value. Technically, it's -$2 out of the money, but the value cuts off at zero.
The same applies to put options where you want the stock price to fall under the strike price. If you have a $50 put option and the stock is trading at $49, then it's $3 in the money. The intrinsic value is $3. If the stock trades at $52, you are -$2 out of the money, and the intrinsic value is zero.
In reality, a $50 call option on a stock trading at $52 may cost $3. We know that $2 is the intrinsic value. The extra money you pay for an option beyond its intrinsic value is called the premium. The premium is made up of volatility and time value. When buying an option, it's best to have a higher intrinsic value than the premium. If you're paying a high premium, remember that the premium can erode as the option gets closer to expiration and volatility drops.
Limitations of intrinsic value
There are limitations to intrinsic value, especially when you apply it to your stocks or portfolio.
- The market is not always logical. You may arrive at a similar intrinsic value stock utilizing many methods, including the DCF. However, the stock may not reach the intrinsic value because the market hasn't figured it out. Conversely, bears and short sellers may find that stock trades much higher than its intrinsic value but continue to get short-squeezed as the market doesn't factor in the same assumptions.
- Market climate may not agree. You may own a stock trading at a deep discount to its intrinsic value. However, the price keeps dropping due to the benchmark index selling off. A positive intrinsic value may not come to fruition in a bear market. The same applies in a bull market. A negative intrinsic value may not come to fruition as the market continues to climb and pull most stocks higher regardless.
- Calculations are assumption-based. As shown in the FCF method for calculating the intrinsic value of EBAY, you have to make many assumptions about future business, including cash flow, financing and growth predictions. A weak earnings report or an earnings warning could cause most of your assumptions to fall by the wayside. Remember that intrinsic value is a hypothetical and educated guess at best.
Intrinsic value: Still just a guess
Intrinsic value should be considered one tool in your arsenal of fundamental and technical tools for stock selection, analysis and management. Nothing is 100% in the stock market. All forecasts, price targets and predictions are just guesses. Some guesses are more accurate than others. To refine your craft, it helps to continue to practice calculating intrinsic value for stocks on your watchlist. The more you practice, the more you can refine your methods and record how accurate your intrinsic values are as they come to fruition.
Since companies are categorized into segments within industries and sectors, it helps to stick to a particular sector initially and keep the apples-to-apples comparisons before branching out to new stocks. Once you perform an intrinsic value calculation, you can continue to watch how the stock performs on your watchlist to become more familiar with its operations and price action.
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