What is intrinsic value?
Intrinsic value is the measurement of how much an asset is worth, given the current financial performance and level of risk. It is a way of assessing the true value of an investment, without other market factors playing a role in the analysis.
There are different ways to arrive at a valuation for an asset, but the intrinsic value is based on objective calculations of both qualitative and quantitive factors, rather than just its current market value. These factors include:
- Business model
- Target markets
- Financial ratios
- Financial statements
Most commonly the term intrinsic value is used to describe the price of a company’s stock. Not all assets have cash flows, which make it difficult to calculate the intrinsic value. For example, commodities or cryptocurrencies themselves do not generate a stream of income, only by market speculation.
What is the intrinsic value of a stock?
The intrinsic value of a stock, or a business, is the combined value of all its expected future cash flows – with the discount rate applied. The intrinsic value only considers the business’ factors (earnings and dividends) rather than any speculation and comparisons to other stocks in the sector.
Financial analysts will build models to assess the intrinsic value of a stock, outside of its perceived market value. The traders who use these models as part of their strategy are known as ‘value investors’ or ‘value traders’.
The theory goes that any differences between the true value of a stock and its current market price can be exploited for profit.
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How to calculate the intrinsic value of a stock
There are a few different ways to calculate the intrinsic value of a stock, the most popular models are:
- Dividend discount-based
- Residual income-based
- Discounted cash flow-based
1. Discounted cash flow model
Discounted cash flow (DCF) analysis is the most common valuation, which simply assesses the cash flows over several future periods. It attempts to assign an intrinsic value based on the projections of how much money a company will make going forwards.
The value of expected future cash flows is calculated using a discount rate – an interest rate that helps determine if cash flows will be worth more or less than in the present.
The discounted cash flow formula requires three values:
- The estimated future cash flow (CF)
- The discount rate (r)
- A method for valuing the company at the end of the cash flow estimate, known as terminal value (TV)
The formula works as follows:
DCF = CF1/(1+r)1 + CF2/(1+r)2 + … + TV/(1+r)n
You’d add a cash flow for any subsequent periods under examination. For example, if you wanted to look two years ahead, five years, ten years, and so on.
If the DCF is above the current cost of the investment, the opportunity could result in positive returns.
2. Residual income model
The residual income model looks at the difference between the earnings per share and per-share book value to calculate the intrinsic value of a stock. It is the income a company generates after accounting for its cost of capital equity. So, it uses shareholders’ earnings opportunities to create a valuation.
The calculation for residual income is net income – equity charge (equity capital multiplied by the cost of equity). The residual income valuation method takes this figure and uses it as follows:
Stock value = the current book value of a company + the sum of the residual income of a company divided by the cost of equity + 1.
The model looks at the company’s economic profitability, but it is a forward-looking estimate so not entirely reliable.
3. Dividend discount model
A lot of models will consider a company’s cash flow. The dividend discount model (DDM) accounts for the company’s ability to pay dividends out to shareholders, reflecting its perceived future cash flow. There are a few different versions of this model, the most basic of which is:
Stock value = expected dividend per share / (cost of capital equity - dividend growth rate)
How does intrinsic value change over time?
The intrinsic value of a company will change over time as its financial performance alters. If a company experiences significant periods of growth that improve its cash flow projections, its intrinsic value will rise. Likewise, if the company experiences a period of downturn and incurs large losses, its intrinsic value will fall.
It’s important to note that changes in the intrinsic value of a company might not be reflected in its share price. For example, some companies – like start-ups – often make huge losses for years, but their share prices rocket on the back of speculation.
Why do shares trade above their true value?
Shares that trade above their true value are ‘overvalued’. This happens when the market price is driven by illogical or emotional decision making that doesn’t reflect the intrinsic value.
Although investors and traders don’t want to pay above the odds for shares, they can get swept along amongst market hype surrounding a stock. This is what happens in speculative bubbles.
Eventually, an overvalued stock will decline in price. This is known as a stock market correction.
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What happens when a stock trades below its intrinsic value?
A stock trading below its intrinsic value is known as an undervalued stock. An undervalued stock isn’t in financial hardship, but its share price does not reflect its current earnings.
Once investors realise a stock is undervalued, they’ll enter the market and the share price will rally. Identifying stocks below their true value and taking advantage of the upswing can be a great strategy for earning profits. But it can be difficult to identify when a share price will rally.
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