The Intrinsic Value of Shares

Berkshire Hathaway CEO Warren Buffett has rightly said: "Never invest in a business you cannot understand."

Do you know the intrinsic value meaning and how the value of your investment is calculated? Many rely on the markets depending on what investors are currently willing to pay for stocks or corporate bonds. However, value investors prefer a more reliable measure of calculating the actual value of an investment – through its intrinsic value.

What is intrinsic value of stock? - The Intrinsic value of a stock is the Net Asset Value that can provide a deeper value to investment and is a fundamental concept that investors use to discover unknown investment opportunities. The DCF, or the Discounted Cash Flow analysis, is used for many intrinsic value calculations. When the market price of an asset is lower than its net asset value, it can be a wise investment.
 

What Is Intrinsic Value?

Intrinsic value meaning -

The inherent value of an investment is the current price minus the strike price of an asset. It measures the importance of an asset that differs from its market price and can give you an idea of whether the investment is undervalued or overvalued.

Intrinsic value is calculated based on cash flows showing the asset's value based on an analysis of its actual financial performance. The most critical measure is Discounted Cash Flow (DCF). DCF is the current value of expected cash flows, discounted at a rate considering the risk associated with the investment. It is crucial to find out estimated future cash flows while using DCF.

It reveals higher values of assets resulting from lower discount rates and higher forecasted cash flows. Many analysts use different cash flows and discount rates that reflect the uncertainties in estimating future performance. Calculating the intrinsic value of stock became in range since the 1950s when Warren Buffet started practicing it.
 

The Importance of Intrinsic Value

For investors, intrinsic value is important because it shows the underlying value of an investment or asset, which is frequently different from its market value. Knowing this might help you determine if an item is overpriced or undervalued in the market. Investors may make well-informed judgments about whether to purchase, sell, or keep an investment by determining its intrinsic worth. 

It could serve as a benchmark for estimating the risks and possible profits of an investment. Before making an investment, you should, however, conduct your own research and/or speak with their financial advisor.
 

How To Calculate The Intrinsic Value?

To determine the intrinsic value of shares or the current value of any investment, whether real estate, stocks, shares, or long-term assets, you can use the DCF method to calculate its Intrinsic Value. Let us see the formula:

What is Intrinsic value of stock?

You need three inputs for Intrinsic Value calculations:

●  Estimated future cash flows
●  The discount rate is used to analyze the current value of future cash flows.
●  A method of valuing the business is called the terminal value.

 Here is the formula to calculate the intrinsic value of stocks:

●  DCF: Discounted cash flow or current inherent value of the company.
●  CF: Cash flow in years one, two, etc.
●  TV: final value.
●   R: The discount rate.

Intrinsic value Example

Let us assume the disposable income for investors of XYZ company as cash flow at Rs. 100 (after adding depreciation and deducting capital expenses) for the last year. If a hypothetical P/E multiple for the S&P 500 is 30, the market value per share of XYZ company is Rs. 3,000 (30 x 100). We use that figure for comparison with the intrinsic value of shares.

Assuming an estimated growth of 5%, the estimated cash flow for each of the 10 years is:

Year 1: Rs. 105.00 (100 x 1.05)
Year 2: Rs. 110.25 (100 x 1.052)
Year 3: Rs. 115.76 (100 x 1.053)and so on
Year 4: Rs. 121.55
Year 5: Rs. 127.63
Year 6: Rs. 134
Year 7: Rs. 140.71
Year 8: Rs. 147.74
Year 9: Rs. 155.13
Year 10: Rs. 162.89

We then discount these cash flows using a yield of 2% and use the formula CF/1 + r. The discounted cash flow for each of the 10 years is:

Year 1: Rs. 102.94 (105/1.02)
Year 2: Rs. 105.97 (110.25/1.022)
Year 3: Rs. 109.08 (115.76/1.023 etc.)
Year 4: Rs. 112.29
Year 5: Rs. 115.60
6th year: Rs. 118.99
7th year: Rs. 122.50
Year 8: Rs. 125.89
Year 9: Rs. 129.80
Year 10: Rs. 133.62

The total discounted cash flow is Rs. 1176.68.

Next, the final year projection should be multiplied by the P/E multiple of 30, That's 162.89 x 30 = Rs. 4886.7.

The discounted amount is

Rs. 4008.79 (4886.7/ 1.0210).

Finally, both the discounted values should be added – for the first 10 years of discounted cash flows and the 10 years of the terminal cash flow for the net asset value:

1176.68 + 4008.79 = 5185.48

This shows that the intrinsic value of share is undervalued and can be considered an investment.
 

Difference Between Market Value and Intrinsic Value?

Intrinsic value and market value are two separate approaches to appraise a firm. Simply said, market value is the amount that the firm is worth to the market, or what it would cost to purchase it. For publicly listed firms, determining market value is straightforward; but, for private companies, it may be a little more difficult. Estimating a company's true worth apart from its market value is known as intrinsic value. Companies with a greater intrinsic worth than market value are sought after by value investors. They consider this to be a worthwhile investment.
 

Intrinsic value of Stock Options

The intrinsic value of stock options is a measure of how much an option is worth based on the current market price of the underlying stock. For a call option, the intrinsic value is calculated by subtracting the strike price from the current stock price. For example, if a call option has a strike price of ₹50 and the stock is currently trading at ₹55, the intrinsic value is ₹52. For a put option, the intrinsic value is the difference between the strike price and the current stock price.

If the stock is trading at ₹40 and the put option's strike price is ₹50, the intrinsic value is ₹102.
Intrinsic value is a key concept in options trading as it helps investors determine whether an option is profitable to exercise. It's important to note that intrinsic value can never be negative; it is either zero or a positive number.
 

Understanding Intrinsic Value’s Pros and Cons

Intrinsic value in finance is the real, fundamental worth of an asset, like a stock or an option, based on comprehensive analysis, without regard to its current market price. Understanding its pros and cons can help you make more informed investment decisions.

Pros:

• True Value Insight: Intrinsic value provides a solid foundation for evaluating whether an asset is overvalued or undervalued. By knowing the true worth, investors can make more rational and less emotional investment choices.
• Informed Decisions: Relying on intrinsic value encourages thorough research and due diligence, leading to better long-term investment strategies. This approach often considers fundamentals like earnings, dividends, and growth potential.
• Risk Management: Understanding the intrinsic value can help investors avoid bubbles and speculative frenzies by focusing on the asset's real value rather than market hype.

Cons:

• Complex Calculations: Determining intrinsic value can be complex and time-consuming, often requiring sophisticated financial models and deep knowledge of the asset.
• Subjectivity: Different analysts might arrive at different intrinsic values for the same asset, leading to varied opinions and potential conflicts in investment decisions.
• Market Discrepancy: Intrinsic value calculations may not always align with the market prices, causing confusion and requiring patience for the market to reflect the true value.
   

Risk Adjusting the Intrinsic Value

The act of accounting for an asset's riskiness in the calculation of its intrinsic value is known as risk adjusting. This is significant since, in theory, riskier assets should be worth less intrinsically than less risky ones.

There are primarily two approaches to risk adjustment:

1. Discounted Rate: The rate used to reduce future cash flows to their present value is known as the discount rate. A lower intrinsic value may arise from a greater discount rate. The discount rate of riskier assets could be higher than that of less risky ones.
2. Certainty Factor: A certainty factor expresses how likely it is that a future cash flow will materialize. If the cash flow has a 100% certainty factor, it is guaranteed to occur, and if it has a 0% confidence factor, it is guaranteed not to occur. Compared to less risky assets, riskier investments could have a lower certainty factor.
 

How to Trade Index Futures?

Trading index futures in India involves understanding the intricacies of the Indian stock markets, particularly the NSE (National Stock Exchange) and BSE (Bombay Stock Exchange). Here's a step-by-step guide:

Learn the Basics: Familiarize yourself with the concept of futures contracts and how they work. Understand terms like margin, leverage, and expiry dates.

Choose a Reputable Broker: Opt for a broker registered with SEBI (Securities and Exchange Board of India). Ensure they offer good customer service and a reliable trading platform.

Open a Trading Account: Submit necessary documents such as PAN card, Aadhar card, bank statements, and passport-sized photographs to open a futures trading account with your broker.

Fund Your Account: Deposit funds into your account. The broker will specify the margin requirements, which is the minimum balance needed to trade futures.

Select an Index: In India, popular indices for futures trading are Nifty 50 and Sensex. Decide which index you want to trade based on your research.

Place Your Trade: Use your trading platform to place buy or sell orders for index futures. Ensure you understand how to use market orders and limit orders.

Monitor the Market: Keep an eye on market trends, news, and economic indicators that may affect the index. This will help you make informed decisions and adjust your strategy.

Close Your Position: When you're ready to exit the trade, place a closing order. This could be to lock in profits or minimize losses.

Trading index futures can be profitable but involves significant risk. It's crucial to have a solid understanding of the market and a well-thought-out strategy. Consider practicing with a demo account before trading with real money.
 

Conclusion

Investors must understand how to calculate the value of an investment using its intrinsic value. The best feature about relying on this value is that it determines the actual value of an investment considering future cash flows and not just where an asset is currently trading. Value investors can measure using the value whether the asset's price is priced correctly or not based on their investment approach.