What is Intrinsic Value?
The intrinsic value of a business, or any investment security is the present value of all expected future cash flows, discounted at the appropriate discount rate. Unlike relative forms of valuation that look at comparable companies, intrinsic valuation looks only at the inherent value of a business on its own. Another way to define intrinsic value is “The price a rational investor is willing to pay for an investment, given its level of risk”. Simply, it refers to what a stock or any asset is actually worth.
Calculation of Intrinsic value :-
The main methods to calculate Intrinsic value are explained below :-
1. Analysis based on Net Present Value (NPV) :-
The standard approach to calculate an Intrinsic value
is based on NPV.
Intrinsic value = (CF0)/(1 + r)0
+ (CF1)/(1 + r)1 + (CF2)/(1 + r)2 +
(CF3)/(1 + r)3 + ... + (CFn)/(1 + r)n
Where:
CF1 is cash flow in year 1, CF2 is cash flow in year 2, etc.
n = number of periods included
Risk Adjusting the Intrinsic Value can be based on two concepts, such as :-
(a) Discount Rate
By using discount rate that includes a risk premium in
it to adequately discount the cash flows. In the discount rate approach, a
financial analyst will typically use a company’s weighted
average cost of capital (WACC).
WACC = [risk-free rate + (volatility of the stock X
equity risk premium)].
Here, risk-free rate is usually a government bond
yield, and volatility is a premium based of the stock.
The rationale behind this approach is that if a stock is more volatile, it’s a riskier investment. Therefore, a higher discount rate is used, which has the effect of reducing the value of cash flow that would be received further in the future, because of the greater uncertainty.
(b) Certainty Factor
By using a factor on a scale of 0-100% certainty of the cash flows in the forecast materializing. A certainty factor, or probability, can be assigned to each individual cash flow or multiplied against the entire net present value (NPV) of the business as a means of discounting the investment. In this approach, only the risk-free rate is used as the discount rate as the cash flows are already risk-adjusted. For example, the cash flow from a U.S Treasury note comes with a 100% certainty attached to it, so the discount rate is equal to yield, say 2.5% in this example. Compare that to the cash flow from a very high-growth and high-risk technology company. A 50% probability factor is assigned to the cash flow from the tech company and the same 2.5% discount rate is used. At the end of the day, both methods are attempting to do the same thing to discount an investment based on the level of risk inherent in it.
2. Analysis based on a financial metric :-
A quick and easy way of determining the intrinsic
value of a stock is to use a financial metric such as the price-to-earnings
(P/E) ratio. The formula for this approach using the P/E ratio of a stock as :
Intrinsic
value = Earnings per share (EPS) x (1 + r) x P/E ratio
where r = the expected earnings growth rate
For instance, ABC company generated earnings per share
of $3.30 over the last 12 months. Assume that the company will be able to grow
its earnings by around 12.5% over the next 5 years, and the stock currently has
a P/E multiple of 35.5. By using these figures, ABC company's intrinsic value
is:
= 3.30 x
(1 + 0.125) x 35.5
= $131.79 per share
3. Analysis based on Asset valuation :-
The simplest way of calculating the intrinsic value of
a stock is to use an asset-based valuation. The formula for this calculation of
an intrinsic value is:
Intrinsic value = [(Sum of a company's assets, both
tangible and intangible) – (Sum of a company's liabilities)]
For example, assume the ABC company's assets totaled
$500 million. Its liabilities totaled $200 million. Then, the intrinsic value
of ABC company would be $300 million for the stock i.e. $500 - $200.
The limitation of this approach is that it does not incorporate any growth prospects for a company. Asset-based valuation can often yield much lower intrinsic values than the other approaches.
4. Analysis based on value of options :-
There is a rock-solid way of calculating the intrinsic
value of stock options that doesn't require any guesswork. The formula for this
calculation of an intrinsic value is:
Intrinsic value = [(Current Stock price – option’s
strike price) x Number of call options]
For example, a given stock trades for $35 per share. we
own 4 call options that entitle us to buy 100 shares per call
option for $30. Then, Intrinsic value of the call option’s stock in this case
would be :
= ($35 – $30) x 400
= $2,000
Options that are not "in the money (ITM),"
meaning that the strike price is greater than the current share price, have no
intrinsic value and are trading only for time value i.e., the potential that
the stock price could increase and drive the option price higher.
Why calculating intrinsic value is useful
The goal of value investing is to seek out stocks that are
trading for less than their intrinsic value. There are several methods of
evaluating a stock's intrinsic value, and two investors can form two completely
different (and equally valid) opinions on the intrinsic value of the same
stock. However, the general idea is to buy a stock for less than its worth and
evaluating intrinsic value can help you do just that.
Challenges with Intrinsic Value
(a) The trouble with calculating intrinsic value is
that it is a very subjective exercise. There are so many assumptions that must
be made, and the final net present value (NPV) is very sensitive to
changes in those assumptions.
(b) Each of the assumptions in the WACC (beta, market
risk premium) can be calculated in different ways, while the assumption around
a confidence or probability factor is entirely subjective.
(c) Essentially, when it comes to predicting the
future, it is, uncertain. For this reason, all the most successful investors in
the world can look at the same information about a company and arrive at
totally different figures for its intrinsic value.
Intrinsic Value vs Current Market Value
Though both the Intrinsic value and market value are
two distinct ways to value a company, Intrinsic value is an estimate of the
actual true value of a company regardless of market value, whereas Market value
is the current value of a company as reflected by the company's stock price, or
how much it would cost to buy it. Therefore, market value may be significantly
higher or lower than the intrinsic value. In a verdict, Value investors look
for companies with higher intrinsic value than market value as a good
investment opportunity.
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