What Is Intrinsic Value?
The intrinsic value of a stock is its true value. It refers to what a stock (or any asset) is actually worth even if some investors think it’s worth a lot more or less than that amount. Intrinsic value is a company’s, stock’s, currency’s, or product’s expected or calculated value based on fundamental analysis. It takes into account both tangible and intangible aspects. Intrinsic value, often known as real value, is not always the same as current market value. It’s also known as the price a rational investor is ready to pay for an investment based on its risk level.
Background
Benjamin Graham and Warrant Buffett are widely considered the forefathers of value investing, which is based on the intrinsic valuation method. Graham’s book, The Intelligent Investor, laid the groundwork for Warren Buffett and the entire school of thought on the topic. The term intrinsic means the essential nature of something. Synonyms include innate, inherent, native, natural, deep-rooted, etc.
Why Is Intrinsic Value Useful?
Investors can make decisions based on current stock prices alone, but this doesn’t paint the full picture of an asset’s worth. With intrinsic value, investors are able to determine what the stock is really worth. This is particularly helpful for value investors who seek out undervalued stocks or other discounted investment options.
Formula
The present value of all future cash flows discounted at an appropriate discount rate is generally considered the fundamental or intrinsic worth of a firm or any investment asset. As a result, the most “common” method is identical to the net present value formula:
NPV = Net Present Value
CFi = Net cash flow for the ith period (for the first cash flow, i = 0)
r = interest rate
n = number of periods
Intrinsic value = (Stock price-option strike price) x (Number of options)
Value investors can calculate the intrinsic value through fundamental analysis. An analyst must consider both qualitative and quantitative elements when using this method.
The company model, governance, and market characteristics are qualitative considerations, while financial statement analysis and the estimated intrinsic value are quantitative factors. The computed intrinsic value is then compared to the market value to determine if the asset is overpriced or undervalued.
Risk Adjusting The Intrinsic Value
The risk of adjusting the cash flow is subjective. It’s an amalgamation of art and science. There are two main approaches:
1. Discount Rate
The analyst typically utilises a company’s weighted average cost of capital in this approach. The risk-free rate (derived from the government bond yield) is frequently added to the weighted average cost of capital, coupled with a premium based on the stock’s volatility compounded by an equity risk premium. The strategy is founded on the basic premise that a stock that is more volatile is a riskier investment, so an investor should expect higher returns. As a result, a higher discount rate is used in this case, lowering the estimated future cash flow value.
2. Certainty Factor
In this procedure, each cash flow is assigned a certainty factor, or likelihood, which is then multiplied by the entire net present value (NPV). This strategy is used to reduce the cost of an investment. Because the cash flows are risk adjusted, the risk-free rate is employed as the discount rate in this method. As a result, the yield rate equals the discount rate. Assume cash flow from a high-growth company with a 50% probability factor. The same discount rate can be utilised because the risk associated with the high-risk asset (in this case, the high-growth company) is already built in with the probability number.
Why Intrinsic Value Is Not Preferred In Technical Analysis
Despite its many advantages, technical analysts reject the concept of intrinsic value. Followers of the technical approach believe that future market trends can be predicted accurately only by analysing past price movements. They believe:
1. Intrinsic Value May Be Unstable:
Intrinsic value is calculated based on a company’s fundamentals as of today. Future fundamentals are an estimate based on your own calculations. It is, thus, a hypothetical figure. This is not dependable. Events in the future may change these fundamentals significantly. For example, if the economy turns up, or if a company acquires another company, its sales may increase dramatically. This will lead to an increase in its intrinsic value. However, these possibilities cannot be factored into intrinsic value calculations in advance. Technical analysis, in contrast, is more adept at predicting them.
2. Market Value May Not Approach Intrinsic Value Sometimes:
Another flaw of fundamental analysis is that prices may not appreciate enough to equal intrinsic value in the future. For example, if we assume that the stock is currently priced at Rs 100. Your relative value analysis suggested that it could appreciate to Rs 115. However, this will only happen if other investors in the market think like you. Only then will they all invest in the stock and make its price go up. However, other investors may not always think like you. This is particularly true of stocks of smaller companies, which are considered too risky to invest in. So, despite a lot of potential, these stocks may never go up. This will keep you from making money, even though your analysis is perfectly accurate. Technical analysis is free from this flaw. This is because it is based on an analysis of historical market trends and stock demand-supply patterns. These are more realistic.
3. Intrinsic Value Estimation Is Not Possible For All Assets Classes:
The last flaw of the intrinsic value approach is that it cannot be used for all asset classes. In case of stocks, there are fundamentals such as future dividends, sales revenue and earnings. So the intrinsic value approach can be used. However, markets also trade in assets such as commodities, metals and currencies. How can you estimate fundamentals for these? For example, if you invest in gold, how can you estimate its future earnings or future dividends? Gold is not a company. It neither earns income nor pays dividends. In such cases, only technical analysis can be used for estimating value
