Intrinsic Value Definition
What’s the true value of a stock? In the vast majority of cases, it is not the market price. In accordance with basic economic theories, the market price is a reflection of the interaction between supply and demand. Intrinsic value, on the other hand, is a mathematical value that provides information on whether a stock is currently under- or overvalued. Understanding the intrinsic value will help you to follow Warren Buffet’s rule of not paying more than USD 1 for USD 1, but instead – and ideally – even less than USD 1. Learn how to calculate the intrinsic value of a stock – and what the limitations of this concept are.
What is Intrinsic Value?
Before making an investment, it is important to understand what a stock is actually worth. The market price is the stock’s current price tag, but this price does not reflect the true value of a stock. The above graph visualizes how the stock price moves around its intrinsic value, at times exceeding (red area -> overvalued) and falling below (green area -> undervalued) its intrinsic value. This graph assumes a very short time horizon where the intrinsic value remains stable. However, due to balance sheet and cash flow developments, a stock’s (or company’s) intrinsic value does change over time.
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Calculating the Intrinsic Value
The first step to calculate the intrinsic value of a stock is to choose a valuation model. You can keep it simple and use an asset-based approach by simply deducting the company’s liabilities from the company’s assets. You will find all relevant data in the company’s financial statement. The asset-based approach is quick and dirty as it is fully based on existing corporate financials – not taking into account the company’s future prospects.
Many economists therefore recommend to use the discounted cash flow (DCF) method. This commonly used method of stock valuation has been very popular since the stock market crash of 1929. In contrast to the asset-based approach, the DCF method requires some kind of estimation. Shortly explained, DCF is the sum of all discounted future cash flows of a company (i.e. the fair value of a company’s future cash flows) by using the weighted average cost of capital (WACC) for discounting. Both, future cash flows and WACC are expected values causing some inaccuracy in this model. Furthermore, people that are not gifted in mathematics will say DCF is quite challenging to calculate – but for those who don’t like to do the maths themselves, you will find pre-prepared DCF-based valuation templates on the web.
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