We have covered a significant portion on value and value investing with focus on value of a stock, value of a company, value per share, valuation methods and even some information on the father of value investing, Mr. Benjamin Graham over the last few articles. If you haven't gone through them, then what are you waiting for?
In this article, we go in depth to calculate the intrinsic value of a stock using various multiples as well as shed some light on the DCF (Discounted Cash Flow) method of valuation. In our article on undervalued stocks, we had covered some multiples along with examples to highlight undervalued stocks and in this one, we will use those same examples to calculate the intrinsic value of those stocks. You will find intrinsic value formula with example below.
Intrinsic, derived from the Latin word intrinsecus meaning "on the inside" is now used today to represent inherent qualities in an object or individual. For e.g. motivation. Some individuals are motivated to perform an activity either to earn a reward or to avoid punishment. This is an externally sourced motivation.
Some on the other hand perform the same activity for their personal goals and satisfaction. They are driven by internal desires that are present in them basis their dreams, nurturing and life goals. Their motivation is internal or intrinsic.
In terms of value, intrinsic value refers to the value that is inherent in that stock or company that we are looking to invest in. This can be applied to any asset in life and not just stocks or companies. For e.g. we all collect rare coins and money bills. For e.g. the United States penny before 1982 contained 95% copper.
The rising prices of copper has made that penny worth a lot more than a penny. While the external value of a penny is just that, one cent, its intrinsic value is actually double i.e. two cents due to the weight of the copper in that penny. Thus those holding the coin are actually holding an undervalued coin if they are to exchange it for one cent of value.
Intrinsic value of stock holds similarly to that of stock. Financial value calculation is made complex but is often straightforward once you get the hang of it. Stock price reflects the value at which one can acquire that stock. However its intrinsic value will be different calculated on the basis of physical assets (Land, machinery etc.) to intangible assets (formula, patents, licenses) and the same can be worth several times more the stock price.
There are some popular multiples well known in the market that are normally used to determine whether a company's stock or company is trading at a discount to its intrinsic value or premium. Those same multiples can be used in various calculators to determine intrinsic value of the company's stock or company as well. Let us look at some of the intrinsic value formula now.
The ratio, often known as PE ratio of a company when compared with its peers tells us whether the company is undervalued or not. The same can be used to calculate intrinsic value by taking a fair estimate of future earnings and current stock price. Consider the following companies:
Now considering that Target's earnings per share remains the same and growth rate remains positive, one can simply multiple industry average PE with Target's earnings to get the intrinsic value of the company's shares. Alternatively, one can also plot the numbers into an excel model for quicker output
As you can see, the fair value or intrinsic value of Target as per the P/E ratio is 450, that is when its PE ratio reaches industry average. If earnings were to grow as well this intrinsic value will go much higher.
This ratio, often known as PS ratio of a company when compared with its peers highlights whether the value of a company basis its revenues is fair or not. Similar to PE we can calculate intrinsic value for investment by a fair estimate of growth rate, revenue cash flow/ cash flows and expanding multiples.
We have taken into consideration, insurance companies whose revenues often translate directly into earnings. Prudential Financial remains highly undervalued while Chubbs remains overvalued. The Intrinsic value of a company like Prudential Financial when it reaches average P/S ratio is high and that combined with revenue growth pushes it quite higher.
The ratios mentioned above are some of the common ones used to compare with industry average for accurate intrinsic value formula application and are commonly used in intrinsic value calculator. A less known but very effective formula to determine value of a company was founded by Benjamin Graham, also known as the father of value investing
The graham number is unique in that it is sector agnostic. It gives absolute value of the stock's price in the market irrespective of its sector. It relies on book value and earnings per share to give fair value of shares in the stock market. Net Net, graham number calculator is a perfect way to get intrinsic value in a couple of clicks.
Benjamin Graham gave the formula as root of (22.5*earnings per share*book value per share). Using this let us compare the companies of the above examples and determine their intrinsic value using Benjamin Graham number.
As one can see, graham number is highly conservative giving severely low intrinsic values. This is one of the reason it is no longer popular. Graham formula can be used fairly for company's hard assets but cannot be used for those with soft assets like software companies.
Discounted Cash Flow or DCF is a valuation model dependent on estimate of /estimated future cash flows. The cash flows are adjusted for inflation by converting them to present value using a discount rate which is equal to inflation or prevailing interest rates.
EPS is the usual starting point from which one moves to free cash flow. A growth rate is to be determined known as terminal growth rate which helps determine final future value. DCF is not prominently used due to the inherent issues with assumptions and its sensitivity to those assumptions.
A lot of assumptions are made on future cash flows dcf, discounted rate, growth rate, stock market returns and terminal growth. There is a lot of scope for mistakes and the value received is often understated or over exaggerated. Thus DCF tends to be the starting point of valuation for investment banks following which they use industry multiples as above for calculating fair price of stocks.
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