"Intrinsic value" is a philosophical concept, wherein the worth of an object or endeavor is derived in and of itself—or, in layman's terms, independent of other extraneous factors. A company's stock also is capable of holding intrinsic value, outside of what its perceived market price is, and is often touted as an important aspect to consider by value investors when picking a company to invest in.
Some buyers may simply have a "gut feeling" about the price of a stock, taking into deep consideration its corporate fundamentals. Others may base their purchase on the hype behind the stock ("everyone is talking positively about it; it must be good!") However, in this article, we will look at another way of figuring out the intrinsic value of a stock, which reduces the subjective perception of a stock's value by analyzing its fundamentals and determining the worth of a stock in and of itself(in other words, how it generates cash).
For the sake of brevity, we will exclude intrinsic value as it applies to call and put options.
Dividend Discount Model
When figuring out a stock's intrinsic value, cash is king. Many models that calculate the fundamental value of a security factor in variables largely pertaining to cash: dividends and future cash flows, as well as utilize the time value of money. One model popularly used for finding a company's intrinsic value is the dividend discount model. The basic DDM is:
Div = Dividends expected in one period
r = Required rate of return
One variety of this model is the Gordon Growth Model, which assumes the company in consideration is within a steady state—that is, with growing dividends in perpetuity. It is expressed as the following:
P = Present value of stock
D1= Expected dividends one year from the present
R = Required rate of return for equity investors
G = Annual growth rate in dividends in perpetuity
As the name implies, it accounts for the dividends that a company pays out to shareholders which reflect on the company's ability to generate cash flows. There are multiple variations of this model, each of which factor in different variables depending on what assumptions you wish to include. Despite its very basic and optimistic in its assumptions, the Gordon Growth model has its merits when applied to the analysis of blue-chip companies and broad indices.
Residual Income Model
Another such method of calculating this value is the residual income model, which expressed in its simplest form is:
BV0 = Current book value of the company’s equity
RIt = Residual income of a company at time period t
r = Cost of equity
If you find your eyes glazing over when looking at that formula—don't worry, we are not going to go into further details. What is important to consider though, is how this valuation method derives the value of the stock based on the difference in earnings per share and per-share book value (in this case, the security's residual income), to come to an intrinsic value for the stock. Essentially, the model seeks to find the intrinsic value of the stock by adding its current per-share book value with its discounted residual income (which can either lessen the book value or increase it.)
Discounted Cash Flow
Finally, the most common valuation method used in finding a stock's fundamental value is the discounted cash flow (DCF) analysis. In its simplest form, it resembles the DDM:
CFn = Cash flows in period n.
Using DCF Analysis, you can use the model to determine a fair value for a stock based on projected future cash flows. Unlike the previous two models, DCF analysis looks for free cash flows—that is, cash flow where net income is added with amortization/depreciation and subtracts changes in working capital and capital expenditures. It also utilizes WACC as a discount variable to account for the time value of money. McClure's explanation provides an in-depth example demonstrating the complexity of this analysis, which ultimately determines the stock's intrinsic value.
Why Intrinsic Value Matters
Why does intrinsic value matter to an investor? In the listed models above, analysts employ these methods to see if whether or not the intrinsic value of a security is higher or lower than its current market price, allowing them to categorize it as "overvalued" or "undervalued." Typically, when calculating a stock's intrinsic value, investors can determine an appropriate margin of safety, where the market price is below the estimated intrinsic value. By leaving a 'cushion' between the lower market price and the price you believe it's worth, you limit the amount of downside that you would incur if the stock ends up being worth less than your estimate.
For instance, suppose in one year you find a company that you believe has strong fundamentals coupled with excellent cash flow opportunities. That year it trades at $10 per share, and after figuring out its DCF, you realize that its intrinsic value is closer to $15 per share: a bargain of $5. Assuming you have a margin of safety of about 35%, you would purchase this stock at the $10 value. If its intrinsic value drops by $3 a year later, you are still saving at least $2 from your initial DCF value and have ample room to sell if the share price drops with it.
For a beginner getting to know the markets, intrinsic value is a vital concept to remember when researching firms and finding bargains that fit within his or her investment objectives. Though not a perfect indicator of the success of a company, applying models that focus on fundamentals provide a sobering perspective on the price of its shares.
The Bottom Line
Every valuation model ever developed by an economist or financial academic is subject to the risk and volatility that exists in the market as well as the sheer irrationality of investors. While calculating intrinsic value may not be a guaranteed way of mitigating all losses to your portfolio, it does provide a clearer indication of a company's financial health, which is vital when picking stocks you intend on holding for the long-term. Moreover, picking stocks with market prices below their intrinsic value can also help in saving money when building a portfolio.
Although a stock may be climbing in price in one period, if it appears overvalued, it may be best to wait until the market brings it down to below its intrinsic value to realize a bargain. This not only saves you from deeper losses but allows for wiggle room to allocate cash into other, more secure investment vehicles like bonds and T-bills.