Intrinsic Value of a Stock and Methods to Value it

The intrinsic value of a share is the theoretical value of a share based on its underlying fundamentals, such as its future cash flows, risk, and growth prospects. It is the price that an investor would be willing to pay for a share if they were completely rational and had all the information about the company.

The intrinsic value of a share is not always equal to its market price. If the market price is below the intrinsic value, then the share is considered to be undervalued. Conversely, if the market price is above the intrinsic value, then the share is considered to be overvalued.

Factors that affect the Intrinsic Value of a Share

• The company's future cash flows: The higher the company's future cash flows, the higher its intrinsic value.
• The company's risk: The riskier the company, the lower its intrinsic value.
• The company's growth prospects: The faster the company is growing, the higher its intrinsic value.
• The discount rate: The discount rate is the rate used to discount future cash flows back to the present day. A higher discount rate will result in a lower intrinsic value.

Significance of Intrinsic Value

Intrinsic value is really important for investors because it helps them figure out if a stock is a good deal or not. Imagine you want to buy a toy that's worth Rs 250, but you find it on sale for Rs 150. That's a great deal, right? In the same way, investors use methods like discounted cash flow to figure out how much a company's stock is truly worth.

If they discover that the real value of a Rs 100 stock is actually Rs 150, they know it's a bargain.

What's cool is that, by knowing this intrinsic value, investors can be smart and safe. They like to have some extra room for safety, just like you'd want to keep some extra money in your piggy bank. So, they might buy the Rs 100 stock with the idea that even if its value drops a little, they're still saving money compared to what it's really worth.

This way, they reduce the risk of losing a lot of money.

For beginners learning about investing, understanding intrinsic value helps them find good deals and make smarter choices when buying stocks. It's like a compass that helps them navigate the stock market and make sensible decisions based on a company's real worth.

Methods to Calculate Intrinsic Valuation

1. Discounted Cash Flow (DCF) Analysis

It is a method of valuing an asset by estimating its future cash flows and discounting them back to the present day. The intrinsic value of an asset is the present value of its future cash flows.

The DCF formula is:

Intrinsic Value = Sum of (Future Cash Flows / (1 + Discount Rate)^n)

where:

Future Cash Flows = The expected cash flows from the asset over a period of time.

Discount Rate = The rate used to discount the future cash flows back to the present day. This rate reflects the risk of the asset and the opportunity cost of investing in the asset.

n = The number of years of cash flows that are being discounted.

For example, let's say you are valuing a company that is expected to generate Rs 1 crore in cash flow in one year, Rs 1.20 Crore in cash flow in two years, and Rs 1.50 Crore in cash flow in three years. If the discount rate is 10%, then the intrinsic value of the company is:

Intrinsic Value = Rs 1 / (1 + 0.10)^1 + 1.20 / (1 + 0.10)^2 + 1.50 / (1 + 0.10)^3 = Rs 3.02 Crores

2. Dividend Discount Model (DDM)

The dividend discount model (DDM) is a method of valuing a stock by estimating the present value of all future dividends that the company is expected to pay. The DDM is based on the idea that the intrinsic value of a stock is equal to the present value of all future cash flows that the stock is expected to generate.

The DDM formula is:

Intrinsic Value = Sum of (Dividends / (1 + Discount Rate)^n)

where:

• Dividends = The expected dividends from the stock over a period of time.
• Discount Rate = The rate used to discount future dividends back to the present day. This rate reflects the risk of the stock and the opportunity cost of investing in the stock.
• n = The number of years of dividends that are being discounted.

For example, let's say you are valuing a stock that is expected to pay a dividend of $1 per share in one year, $1.05 per share in two years, and $1.10 per share in three years. If the discount rate is 10%, then the intrinsic value of the stock is:

Intrinsic Value = $1 / (1 + 0.10)^1 + $1.05 / (1 + 0.10)^2 + $1.10 / (1 + 0.10)^3 = $2.94

Variations of the dividend discount model:

1. Constant growth dividend discount model (Gordon model): This model assumes that the dividends grow at a constant rate in perpetuity.
2. Two-stage dividend discount model: This model assumes that the dividends grow at a constant rate for a period of time and then grow at a different rate in perpetuity.
3. H-model dividend discount model: This model assumes that the dividends grow at a constant rate until a terminal value is reached.

3. Residual Income Model:

The residual income model is an intrinsic valuation method that calculates the value of a company based on the amount of income that the company is expected to generate in excess of its cost of capital. The residual income model is based on the idea that a company is only worth investing in if it can generate a return on its capital that is greater than the cost of that capital.

The formula for the residual income model is:

Intrinsic Value = Book Value + Sum of (Residual Income / (1 + Discount Rate)^n)

where:

• Book value = The book value of the company's equity.
• Residual Income = The income that the company is expected to generate in excess of its cost of capital.
• Discount Rate = The rate used to discount the future residual income back to the present day. This rate reflects the risk of the company and the opportunity cost of investing in the company.
• n = The number of years of residual income that are being discounted.

The residual income is calculated as follows:

Residual Income = Net Income - Cost of Capital * Equity

where:

• Net Income = The company's net income after taxes.
• Cost of Capital = The company's cost of capital, which is the rate of return that the company needs to earn on its investments in order to satisfy its investors.
• Equity = The company's equity, which is the value of the company's assets minus the value of its liabilities.

The intrinsic value of a share is not always easy to calculate, and it can be affected by a number of factors. However, it is an important concept for investors to understand, as it can help them make more informed investment decisions.