Everything is not what it seems. This applies a lot more to stocks than anything in the world. Just because a meme frenzy caused a stock price to shoot up, it may not always be worth it. People going with this frenzy often end up losing their hard-earned money when this stock nosedives after losing its artificial momentum. So, the best way to analyze the worth of a stock could be through its intrinsic value.
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What is the intrinsic value of a stock?
Intrinsic value is a philosophical idea in which an object’s or endeavor’s worth is derived without the influence of other external causes. Financial experts use models to estimate what they believe is a company’s intrinsic worth, which is different from what the stock’s perceived market price is on any day.
The difference between market pricing and an analyst’s projected intrinsic value is used to determine whether an investment opportunity exists. Value investors are people who believe that such models are relatively good estimates of intrinsic value and who would invest based on those estimates.
Many investors simply act on a hunch or just go where the market trend takes them. But, having an objective perception based on the company’s fundamentals is the best way to know its true worth. Oftentimes, this intrinsic value may not even be reflected in the market price of the stock.
Why must you know the intrinsic value of a stock?
By knowing the intrinsic value, you can estimate whether a stock price is undervalued or overvalued in the market. This can help you time your investments as per your margin of safety. This “safety cushion” helps you minimize the amount of downside you’ll face if the stock ends up being worth less than your estimate.
Let’s assume you discover a company with great fundamentals and high cash flow potential within a year. It is currently trading at $10 a share, and you determine that its intrinsic worth is closer to $15 per share. If your margin of safety is 35%, you would buy this stock at its current price of $10. Even if its intrinsic worth falls by $3 a year later, you’ve saved at least $2 on your initial DCF value and have plenty of space to sell if the share price falls as well.
Intrinsic value is an important notion for a newbie learning the markets to remember while investigating organizations and discovering deals that match within his or her investment objectives. Though not a perfect predictor of a company’s performance, using models that focus on fundamentals gives a sobering perspective on its share price.
To use it effectively, you need to find the intrinsic value of stock first. Let’s discuss some techniques to calculate the intrinsic value in the next step.
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Discounted Cash Flow Analysis
Many experts think that the Discounted Cash Flow model is the best way to find the intrinsic value of a stock. It is also the most widely used technique across the world. This approach focuses on the time value of money. A $100 you have now is worth more than $105 you are going to have 2 years into the future.
So, the cash flow generated by a company is not going to remain the same value after factoring in its inflation and growth rate. This is why we need to discount it first.
DCF can be performed in the following ways:
Step 1: Determine the future cash flow of the company
Step 2: Determine the rate of return you could get by investing the money in other things
Step 3: Sum up the cash flow values and find the intrinsic value
The formulate we use for calculating DCF is CF/(1+r)^n
Here, CF is the cash flow amount, r is the rate of return and n is the period.
Let’s say a company is generated $100 million in cash flows every year for the next five years. Also, you could get a return of 10% on your money by investing it somewhere else. To find the intrinsic value of the company, you must apply a formula like this.
Intrinsic value = 100M/(1+0.1)1 + 100M/(1+0.1)2 + 100M/(1+0.1)3 + 100M/(1+0.1)4 + 100M/(1+0.1)5
Intrinsic value = $378 million
Even though the company is generating $500 million in the next 5 years, its present-day intrinsic value is only $378 million as per the discounted cash flow model.
Here, finding the cash flow of a company is a little tricky. You may have to go through its past data and assume a certain percentage of growth in the subsequent years.
Price to Earnings Ratio Analysis
If you find the above method complicated, there is a simple way to estimate a value close to the intrinsic value of a stock. It uses the price-to-earnings ratio as a key determining factor. The formula used for calculation goes like this:
Intrinsic value = EPS * (1+r) * P/E ratio
EPS is earnings per share
R is the expected growth rate
P/E ratio = market value per share/earnings per share
Let’s take Walmart stock for example. In FY 2021, it generated an EPS of $4.75. Its stock price closed at $139.55 on February 3rd. Its PE ratio is 29.38. Its growth rate is expected to be around 6.5% in 2022.
Its intrinsic value can be calculated as,
IV = 4.75 * (1 + 0.06) * 29.38
Intrinsic Value = 147.93
So, the intrinsic value of Walmart is $147.93 per share.
Dividend Discount Model
The cash flow of a company plays a key role in determining its intrinsic value under many potential calculations. In the dividend discount model, we determine the company’s current intrinsic value based on its future dividend payout expectations. The basis of the dividend discount model comes from future value calculations.
For instance, future value of a stock = present value * (1 + expected growth rate)
Hence, present value = future value/(1 + growth rate)
The dividend discount model just takes this calculation up a notch. Under this model, the formula for the present value is as follows:
Present value = D/(r-g)
Here, D is the expected dividend amount in the future year(s), r is the return on equity for investors, and g is the expected dividend growth rate.
For example, Walmart recently paid a cash dividend of $2.20 per share in 2021. Its cost of equity (r) is 6.5%, and its expected growth rate is 4.8%.
Hence, the present value = 2.20/(6.5% – 4.8%) = $129.41
One major limitation of the dividend discount model is that it works only for established companies with a history of steady dividend payouts. Companies with inconsistent payments cannot be estimated under this model.
This is the simplest way to calculate the intrinsic value of a stock. However, it may not be the best option. It gives you a straightforward value that is easy to determine.
You can determine the value by subtracting the liabilities of the company from its total assets.
Intrinsic value = Total assets (both tangible and intangible) – Total liabilities
For instance, a company has total assets worth $700 million, and its total liabilities are worth $300. Then, the intrinsic value can be $400 million.
Asset-based valuation provides a simple value, but it doesn’t take into account the company’s growth potential in the near future.
The purpose of value investing is to find stocks that are undervalued in comparison to their inherent worth. There are various approaches for determining a stock’s intrinsic value, and two investors might have radically different (but equally legitimate) views on the same stock’s intrinsic value. The fundamental concept is to acquire a stock for less than it is worth and calculating intrinsic value can assist you in doing so.
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