how to calculate the intrinsic value of a stock
How much are stocks worth? You could just stick with the stock’s present price. But the market’s whims can affect that price. Finding the intrinsic value of the stock is an additional option. A stock’s genuine value is determined by its intrinsic value. It refers to the true value of a stock (or any asset, for that matter), regardless of whether some investors believe it to be worth significantly more or less.
You might believe that determining intrinsic worth would be challenging. But that’s not the case. You can utilise a stock’s intrinsic value to not only find out how much it is worth, but also to find the greatest deals available. It is helpful to understand an investment’s intrinsic worth, particularly if you’re a value investor looking to purchase stocks or other investments at a discount.
Intrinsic value of stocks
How straightforward is it to determine a stock’s intrinsic value? It Depends on the method you employ. Yes, there are a few different options to choose from. We’ll examine three of the most often used methods.
Discounted cash flow analysis
According to some economists, discounted cash flow (DCF) analysis is the most accurate method for determining a stock’s intrinsic value. You must carry out a DCF analysis in three steps:
- All future cash flows for a company should be estimated.
- The present value of each of these upcoming cash flows should be determined.
- To get the intrinsic value of the stock, add all the present values.
The hardest step is by far the first one. The abilities of Warren Buffett and Nostradamus must be combined in order to predict a company’s future cash flows. Most likely, you’ll have to examine the company’s financial accounts (unsurprisingly, previous cash flow statements would be a good place to start). To predict how cash flows might alter in the future, you’ll also need to have a solid understanding of the company’s growth possibilities.
The method for determining an intrinsic value using discounted cash flow analysis is as follows:
Intrinsic value = (CF1)/(1 + r)^1 + (CF2)/(1 + r)^2 + (CF3)/(1 + r)^3 + … + (CFn)/(1 + r)^n
- CF1 is cash flow in year 1, CF2 is cash flow in year 2, etc.
- r is the rate of return you could get by investing money elsewhere
Imagine you wish to conduct a discounted cash flow analysis on the stock of a company called RoboBasketball, which manufactures a remote-controlled drone that resembles a basketball (ticker:DUNK). You examine the company’s most recent cash flow statement and discover that it earned $100 million in cash flow in the previous 12 months. You predict that RoboBasketball’s cash flow will increase by 5% annually based on the company’s growth potential. The intrinsic value of RoboBasketball at a rate of return of 4% would be somewhat more than $2.8 billion based on discounted cash flows projected out over a 25-year period.
Analysis based on a financial metric
Using a financial statistic like the price-to-earnings (P/E) ratio is a quick and simple approach to calculate a stock’s intrinsic value. The formula for this strategy using a stock’s P/E ratio is as follows:
Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio
where r = the expected earnings growth rate
Let’s assume that over the previous 12 months, RoboBasketball produced earnings per share of $3.30. Assume that during the following five years, the company will be able to increase its earnings by about 12.5%. The stock currently has a P/E multiple of 35.5. Let’s assume this number will increase. Using these numbers, the intrinsic value of RoboBasketball is:
($3.30 per share) x (1 + 0.125) x 35.5 = $131.79 per share
Using an asset-based valuation is the simplest method for determining a stock’s intrinsic value. This calculation’s formula is easy to understand:
Intrinsic value = (Sum of a company’s assets, both tangible and intangible) – (Sum of a company’s liabilities)
What inherent value does this method bring to RoboBasketball? Assume the corporation had $500 million in assets. $200 million was the sum of its obligations. The intrinsic value of the stock would be $300 million after deducting the liabilities from the assets.
However, there is a drawback to asset-based valuation: It ignores a company’s potential for future growth. When compared to the other methods, asset-based valuation can frequently produce substantially lower intrinsic values.
Calculating the intrinsic value of options
There is a foolproof method for determining the intrinsic value of stock options that doesn’t involve any speculation. The equation you must use is as follows:
Intrinsic value = (Stock price-option strike price) x (Number of options)
Consider a stock that sells for $35 per share. You have four call options that give you the right to purchase 100 shares for $30 each. What is the inherent worth of your choices? It’s easy to calculate:
($35 – $30) x (400) = $2,000
Options with a strike price higher than the current share price and not “in the money” have no inherent value and are only traded for temporal value (i.e., the potential that the stock price could increase and drive the option price higher).
Why calculating intrinsic value is useful
Finding stocks that are trading for less than their intrinsic value is the aim of value investing. The intrinsic value of a stock can be determined using a variety of approaches, and two investors may have completely different (but equally legitimate) views on it. The goal is to purchase a stock for less than it is worth, and determining intrinsic value can assist you in doing just that.
How to Calculate the Intrinsic Value of a Stock Conclusion
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