In today’s article, we will discuss how to find the intrinsic value of the stock. Whenever we invest in the stock for the long term through fundamental analysis, we should consider the intrinsic value of the stock before making an investment decision.
What is Intrinsic Value of the Stock?
Intrinsic value is the calculation of what is the company’s asset’s worth. This is derived by the calculation of various fundamental parameters of the company rather than the current stock price. The first time when I heard about Intrinsic value, I got scared. I was thinking that this must be some complex calculation that is out of my reach.
Thankfully, when I learned it, I found it easy. We all know the price of the stock is moving up and down within a fraction of a second. There is some good or bad news, and the stock price will follow that news. These are called time and event-based movements. This actually never changes the fundamentals of the company. The business which a company is doing is not going to change every minute.
For example, The stock price of HDFC Bank may go up or down by 4-5% on a single day. But as a business, as a brand, HDFC Bank can never fall 4-5% in a single day.
So the point here is, we cannot buy the share based on the event-based ups and down. If we want to buy a share, we want to know its real value. This value is called the Intrinsic value of the company.
Why We Should Find the Intrinsic Value of the Stock?
If we don’t find the intrinsic value of the stock, we might have to purchase a stock at a high value. This may result into the lower profit gain from the stock. Also, it is very much important to know and calculate the fundamentals of the company you are investing in. Here are the reasons why you should care about the intrinsic value of the company.
- To check the fundamentals of the company.
- The company’s ability for a sustainable business.
- To check whether the current price is high or low.
- Timely investment decision.
In the stock market, whatever is the current price of the stock is not the actual value of that business. So there are instances where we could end up paying more for the stock and then the price will come down and we lose money.
So to avoid such a scenario and invest at the right time in the right company, we should know the intrinsic value of the stock.
How to Find Intrinsic Value of the Stock?
Well, there are different ways of finding an intrinsic value of the stock. There is no fixed scientific rule to find the intrinsic value of the company. Which way is right, which is wrong, there is no rule for that as well. It is an art of understanding the business and its value. There are various ways of measuring the intrinsic value of the company, those are as below.
Book Value – Intrinsic Value
Let’s understand this with an example. There is a car in the dump yard. Totally nonworking car. What could be the value of that car according to you? For me, it is worth only the iron scrap. So to calculate the intrinsic value of that car, the formula would be Iron scrap rate X weight of the iron scrap. We can call this the book value, intrinsic value method.
What is the cash balance laying in the bank account, what is the material value laying in the factory store, factory building value, land value, etc? The total of all these would be the intrinsic or the fair value of the company.
Here we compare different companies and try to find out which one is within our budget. Usually, we think the company which fits our budget is the best company. We may compare HDFC with ICICI, or HDFC with SBI. Though the comparison is not completely accurate as we are not comparing both the at a same level. We find such a similar company in terms of their market value, revenue, profits, debt, etc. But in real-world, the things are not as easy as it looks.
We should not blindly go with this relative comparison, as there may be a case where the company is earning high but the market is responding in a negative way in price value. There could be some reason why the stock price is going down even if the earnings are high. So the learning here is ‘Cheap is not always Good’.
Comparison with other Asset class
Let’s take an example of bank fixed deposit. If the bank fixed deposit is earning you 15% return without any risk, would you still invest in the stock or mutual funds? I would certainly not invest. Why? because I will check the return with the other asset class and compare the returns they are giving vs stock is giving.
today, when the bank fixed deposit is giving only a 5% return, the return of 10% from the stock looks good to me. So it is all relative comparison with the other asset class.
Today, if the gold crashes by 50% we all will go behind gold as it looks more lucrative than the stock market. Money is the scarce resource and we have many investment avenues like stock, mutual funds, bank FD, gold, etc. So we always do a comparison on the return earned from all these asset class.
Future Value of the Business
Let’s assume that you want to buy a running store. There are various items sold which are always in demand. You know how much the revenue of the store and value of its inventory. Now before making a purchase decision, you would obviously calculate the future revenue of the store. What would be the demand in the future for the items sold through the store and what would be the revenue etc.
Or, there is a second option that you give that store to someone on rent and enjoy the monthly fixed income from the rental. So in this case, you would know the future revenue from this asset. Now based on that future value of the business, you would make your purchase decision. The price at which you would buy that store today is the intrinsic value of the store for you. this method is called Discounted cash flow (DCF). Here we are discounting the current value of the store from its future value.
Intrinsic Value Formula
The formula for calculating the intrinsic value under DCF method is as follows:
Technically, the intrinsic value of a stock is defined as the present value of all the free cash flows (FCF) discounted at the rate of weighted average cost of capital (WACC).
Limitations of Calculating Intrinsic Value of the Company
The above formula is the simplest way of explaining the intrinsic value of the stock, but there are various loopholes in the above method. Like, what about inflation, market risk, competition, and so on. So basically it is person to person and company to company. If you buy something which is below its worth, then you have bought it below its intrinsic value.
Intrinsic value is subjective from person to person because its value differs from person to person. Imagine, you are in a desert and thirsty. At this moment you would be ready to pay ₹ 1000 for a water bottle which actually worth ₹ 10. Why? because the value of that bottle is high for you while you are in the desert. So the lesson to learn is: It is what you want, determines the value.
That is the reason I have not given any formula here for calculating the intrinsic value of the company. If value means different things to different people then, how can one restrict it to one formula?
I would recommend not to use any formula for the calculation of the intrinsic value of the company because it will not help you make any purchase decision and will make you confused.
If you have cleared the concept of intrinsic value from my explanation then there really is no need to use and learn the formulas…