How To Calculate the Intrinsic Value of a Stock

Most investors focus on the current stock price, which is often driven by market trends and fluctuations. But is the stock really worth that price? That’s where intrinsic value comes in. As a value investor, understanding a stock’s intrinsic value is essential. It reflects the true worth of the company, not just what the market says. By doing so, you can identify strong-performing stocks, make smarter investment decisions, and avoid falling for market hype.

This blog teaches you how to calculate the intrinsic value of a stock by using different methods.

Intrinsic Value of Share or Stock

Intrinsic value is the estimated true value of a company’s stock, based on its fundamentals. It differs from the market price, which can be influenced by investor sentiment, news, and market trends. Intrinsic value is typically calculated through fundamental analysis, which considers factors like cash flow, assets, earnings, and both tangible and intangible elements.

When a stock’s market price is below its intrinsic value, investors may see it as undervalued and choose to buy. Conversely, if the market price is above the intrinsic value, it might be considered overvalued, and investors may choose to sell. Understanding intrinsic value is crucial for value investors, as it helps them make more informed decisions based on a company’s actual performance and potential, not just market hype.

Why Is Calculating Intrinsic Value Useful?

Calculating the intrinsic value of a stock is vital, as it considers both quantitative and qualitative aspects of a share. Investors use intrinsic value to compare with the current market price and determine whether a stock is overvalued or undervalued.

If a stock is undervalued, it may signal a buying opportunity. If it’s overvalued, it may suggest a selling opportunity. Since the calculation is based on data from financial statements, such as revenue, earnings, and cash flow, it helps investors get a clearer picture of the company’s financial health and performance.

How To Find the Intrinsic Value of a Stock?

Here are the most common methods used by investors to calculate a stock’s intrinsic value:

• Discounted Cash Flow Analysis

The most common method used for calculating intrinsic value is discounted cash flow analysis, also known as DCF analysis. It gives the true value of a company’s stock, including elements like free cash flow. It showcases the ability of an organisation to generate cash after taking into account all the operating expenses and the investments required to sustain and grow the business. The following steps should be followed in order to get the value:

• Calculate the future cash flow of the company.
• Next, compute the present value of all the estimated future cash flows.
• Add all these present values to know the intrinsic value of a stock.

Intrinsic value = (CF1)/(1 + r)1 + (CF2)/(1 + r)2 + (CF3)/(1 + r)3 + … + (CFn)/(1 + r)n

Where:

• CF1 is the first-year cash flow, CF2 is for the second year, and so on.  
• r = rate of return as per market standards.

• Financial Metric Analysis

Financial metrics can be a helpful way to estimate a stock’s intrinsic value. One approach involves using the company’s Earnings Per Share (EPS) and its Price-to-Earnings (P/E) ratio in a simple formula:

Intrinsic Value: Earnings per share (EPS) x (1 + r) x P/E ratio

‘r’ here indicates the expected growth rate of the earnings.

• Asset-Based Valuation

The asset-based valuation method to calculate the intrinsic value of a stock is best suited for new investors since it does not involve complex calculations.

Intrinsic Value: Total Assets – Total Liabilities
A company’s assets consist of both tangible and intangible assets, and liabilities include all the debt owed by the company. The drawback of this method is that it does not take into account the company’s growth potential. Therefore, using this method does not help you much in finding a true stock value.

• Dividend Discount Models

Dividend discount models (DDM) are one of the oldest methods to calculate the intrinsic stock value. It is done by equating stock values at present to the sum of all the future dividend payments, discounted back to present value. This method demonstrates the fundamental principle of value investing, indicating that a company’s assets are worth the cash they can generate for investors.

Intrinsic Value = EDPS/(CCE – DGR)

Here:

• EDPS = Expected dividend per share
• CCE = Cost of capital equity
• DGR = Dividend growth rate

The Dividend Discount Model (DDM) provides three key insights into intrinsic value: the expected future cash flows from dividends, the level of risk associated with the investment, and the company’s potential for growth.

Conclusion

Calculating intrinsic value is essential for assessing whether a stock is overvalued or undervalued, enabling investors to make well-informed decisions. Since different sectors and companies have unique financial dynamics, it’s important to choose the most suitable valuation method based on the company’s fundamentals and industry characteristics. A thoughtful approach to valuation can provide clearer insights and improve long-term investment outcomes.

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Frequently Asked Questions (FAQs)

• How to calculate the intrinsic value of a stock?

There are many ways to calculate the intrinsic value of a stock. However, the most common method is the discounted cash flow (DCF) model:

Intrinsic value formula = (CF1)/(1 + r)1 + (CF2)/(1 + r)2 + (CF3)/(1 + r)3 + … + (CFn)/(1 + r)n

Where:

1. CF1 is the first-year cash flow, CF2 is for the second year, and so on.  
2. r = rate of return as per market standards.

• What is the procedure for calculating intrinsic value?

The intrinsic value is a stock’s true value calculated based on fundamental analysis. It can be calculated using multiple methods, such as discounted cash flow analysis, asset-based valuation, and dividend discounted models.

• How do we calculate the intrinsic value of stock options?

The intrinsic value of a stock option, whether it is a call or put, is calculated by finding the difference between the current stock price and the option’s strike price. For call options, subtract the strike price from the current stock price. For put options, subtract the current stock price from the strike price.

• Which method does Warren Buffett use to calculate intrinsic value?

Warren Buffett uses discounted cash flow (DCF) to calculate intrinsic value. The DCF model involves focusing on companies with predictable earnings and strong cash flows, then discounting those future earnings to arrive at the present business value.