The first reference point for selecting stocks for investment is usually their current market price. However, this price in itself provides limited insights into the stock valuation. Therefore, it is important to know the intrinsic value of shares to have an optimum benchmark for valuation. Check out this blog to learn the meaning of the intrinsic value of stock and other details on this topic to ensure a sound investment portfolio.
The intrinsic value of a share is the true, underlying worth of a company's stock based on its fundamentals, such as earnings, growth potential, and assets. It helps investors determine if a stock is undervalued or overvalued compared to its current market price.
It's an estimate of the share's worth, considering factors like the company’s financial health and future performance. Investors can thus use this metric to make more informed decisions about buying or selling stocks.
Several formulas can be used to calculate the intrinsic value of stocks. One of the most common methods is the DCF method.
The formula for calculating the intrinsic value of stocks using the Discounting Cash Flow (DCF) method is as below.
Intrinsic Value = [CFi / (1+r) ^1] + [CFii / (1+r) ^2] +…..+ [TV / (1+r) ^ n]
Where,
CF is the yearly cash flow
r is the discounting rate (usually the cost of capital)
TV is the terminal value of cash flow in the final year
As explained above, the DCF model is one of the most popular methods for calculating the intrinsic value of shares. Understanding these methods can help investors better evaluate a stock’s worth and make more informed investment decisions.
Here are the other popular methods to calculate the intrinsic value of shares.
The DDM evaluates companies that pay regular dividends. It calculates the intrinsic value by discounting the expected future dividends to their present value.
Formula -
Intrinsic Value = D1 / (r−g)
Where,
D1 - Expected dividend in the next year.
r - Required rate of return.
g - Growth rate of dividends.
This method uses the company’s earnings to estimate its value. It compares the stock’s current price to its earnings per share (EPS).
Formula -
Intrinsic Value = Earnings per share (EPS) x (1 + r) x P/E ratio
Where,
r = expected growth rate of earnings
Asset-based valuation calculates the intrinsic value based on the company’s net asset value, which is the value of its assets minus its liabilities. This method is often used for companies with significant tangible assets.
Formula -
Intrinsic Value = Total Assets−Total Liabilities
The RIM calculates intrinsic value by considering the company’s residual income earned above the required return on equity. This method is helpful for companies where earnings exceed the cost of equity.
Formula -
Intrinsic Value = Book Value + ∑ [ Residual Income / (1+ Discount Rate)^n]
Here is an example of calculation of Intrinsic value of a share through DCF method. We will focus only on the returns required by equity investors, and not the cost of debt. So the Cost of Equity will be calculated using the Capital Asset Pricing Model (CAPM).
1. Calculate the Cost of Equity (Using CAPM)
The Cost of Equity can be calculated using the CAPM formula which is
Cost of Equity (Re) = Rf + beta(Rm - Rf)
Where:
Rf = Risk-free rate (e.g., 10-year Indian government bond yield)
beta = Beta of the stock (how volatile the stock is compared to the market)
Rm = Expected market return (e.g., average return from Indian equity markets)
Example
Let's assume the following values:
- Risk-free rate ( Rf) = 7% (Indian government bond yield)
- Beta = 1.2 (stock is slightly more volatile than the market)
- Expected market return ( Rm) = 12%
- Re = 7% + 1.2 (12% - 7%) = 13%
2. Forecast the Free Cash Flows (FCFs)
Let’s assume these are the Free Cash Flows available to the equity investors of the company
- Year 1: ₹500 crore
- Year 2: ₹550 crore
- Year 3: ₹605 crore
- Year 4: ₹665 crore
- Year 5: ₹732 crore
3. Calculate the Present Value of Free Cash Flows
Now, we discount the future cash flows using the Cost of Equity (13% as calculated above).
Present Value Formula = PV of FCF in Year X=FCF in Year X / (1+Re)^x
Example (using 13% as the discount rate):
- PV of Year 1: = ₹500/{(1 + 0.13)^1} = ₹442.48 crore
- PV of Year 2: = ₹550/{(1 + 0.13)^2} = ₹431.87 crore
- PV of Year 3: = ₹605/{(1 + 0.13)^3} = ₹419.49 crore
- PV of Year 4: = ₹665/{(1 + 0.13)^4} = ₹405.19 crore
- PV of Year 5: = ₹732/{(1 + 0.13)^5} = ₹389.73 crore
4. Calculate the Terminal Value
After year 5, we calculate the terminal value, which represents the company's value beyond year 5, assuming a constant growth rate.
Terminal Value Formula: Terminal Value = FCF in Final Year \ (1 + g)(Re - g)
Example
Let’s assume the perpetual growth rate of this company to be 3%.
The terminal value at the end of year 5 is: ₹732 \ (1 + 0.03)(0.13 - 0.03) = ₹7,531.96 Cr
5. Calculate the Present Value of Terminal Value
Like the cash flows, the terminal value is discounted back to its present value.
Present Value of Terminal Value = ₹7,531.96/ {(1 + 0.13)^5} = ₹4,085.05 Cr
6. Calculate the Total Equity Value
The total equity value is the sum of the present values of the forecasted free cash flows and the present value of the terminal value.
Total Equity Value = Sum of PV of FCFs + PV of Terminal Value
Total Equity Value = ₹442.48 + ₹431.87 + ₹419.49 + ₹405.19 + ₹389.73 + ₹4,085.05 = ₹6,173.81 Cr
7. Divide by the Number of Shares
Finally, to find the value per share, divide the total equity value by the number of shares outstanding.
If the company has 50 crore shares outstanding, the value per share is:
₹6,173.81/50 = ₹123.48
Based on the DCF method using the Cost of Equity, the intrinsic value of the company's shares is ₹123.48 per share. If the current market price is below this, the stock could be undervalued; if above, it might be overvalued.
This method is often preferred when the company has little or no debt, or when focusing on the perspective of equity holders.
It is essential to consider the risks associated with the investment when calculating the intrinsic value of a stock. Risk adjustment ensures that the estimated value accurately reflects the potential uncertainties and challenges the company may face. This helps investors avoid overestimating the stock’s true worth.
Investors can use the DCF model effectively for risk adjusting the intrinsic value by increasing the discount rate in the Discounted Cash Flow (DCF) model or applying a margin of safety.
Increasing the discount rate lowers the present value of future cash flows, reflecting higher risk.
Another approach is to apply a "margin of safety," where investors only buy the stock if its market price is significantly below the intrinsic value. This cushion protects against errors in valuation and unexpected risks, making the investment safer.
Analysing the intrinsic value of shares is an integral part of the fundamental analysis of stocks and is crucial for making informed investment decisions. It helps investors in estimating the true value or worth of the stock making it easier to determine optimum entry and exit points for an investment.
Intrinsic value is the true worth of a stock based on a company's fundamental factors like earnings, growth potential, and assets. It helps investors determine if a stock is priced fairly compared to its actual value.
There are several methods to calculate intrinsic value including the Discounted Cash Flow (DCF) analysis, Dividend Discount Model (DDM), Price-to-Earnings (P/E) Ratio, Asset-Based Valuation, and Residual Income Model (RIM).
The intrinsic value of an option is the immediate profit from exercising it, calculated as the difference between the spot price and the strike price. The option value, or premium, includes both the intrinsic value and the time value, which accounts for the potential future value of the option
Investors can find the intrinsic value of Indian stocks on financial websites using various calculators and financial analysis tools available on such portals or by using intrinsic valuation models like DCF analysis or P/E ratio based on data from the company's financial statements.