Intrinsic value is a concept that is used to determine the true value of a stock, bond, or other security. It is the value of an investment based on its underlying fundamentals, rather than its market price. In other words, intrinsic value is the true worth of an investment, independent of its current market price.
The concept of intrinsic value was first introduced by Benjamin Graham, a famous value investor and the father of security analysis. He believed that a stock’s intrinsic value is the present value of all of its future cash flows, discounted at an appropriate rate.
Calculating intrinsic value can be a complex process and there are several different methods that can be used. Some of the most common methods include:
- Discounted Cash Flow (DCF) Analysis: This method involves estimating the future cash flows of a company and discounting them back to their present value using a discount rate. The present value of all of the future cash flows is then considered to be the intrinsic value of the stock.
- Price-to-Earnings (P/E) Ratio: This method compares the current market price of a stock to its earnings per share (EPS). A low P/E ratio indicates that a stock is undervalued, while a high P/E ratio suggests that it is overvalued.
- Price-to-Book (P/B) Ratio: This method compares the market price of a stock to its book value (the value of a company’s assets minus its liabilities). A low P/B ratio suggests that a stock is undervalued, while a high P/B ratio indicates that it is overvalued.
- Dividend Discount Model (DDM): This method involves estimating the future dividends of a company and discounting them back to their present value using a discount rate. The present value of all of the future dividends is then considered to be the intrinsic value of the stock.
It’s important to note that intrinsic value is a theoretical value, and it’s hard to find out true intrinsic value of a stock as it’s difficult to predict future cash flows and dividends. The intrinsic value of a stock can be different from its market value, and it’s important for investors to consider both when making investment decisions.
In Simple Words:
Intrinsic Value is a crucial concept for value investors to understand as it helps them determine whether a stock is undervalued or overvalued. Intrinsic value can be calculated using several different methods, including the Discounted Cash Flow (DCF) Analysis, Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio, and Dividend Discount Model (DDM). By using these methods, investors can determine the true worth of an investment and make more informed decisions.
An example of intrinsic value calculation using the discounted cash flow (DCF) method
Let’s say that an Indian company named XYZ Ltd, has projected cash flows of INR 100 crore (1 billion) for the next five years. The company’s current market price is INR 500 per share. The discount rate used for this calculation is 15%.
Year 1: INR 100 crore / (1+0.15)^1 = INR 86.96 crore Year 2: INR 100 crore / (1+0.15)^2 = INR 75.32 crore Year 3: INR 100 crore / (1+0.15)^3 = INR 65.09 crore Year 4: INR 100 crore / (1+0.15)^4 = INR 56.24 crore Year 5: INR 100 crore / (1+0.15)^5 = INR 48.62 crore
The present value of all of the future cash flows is INR 342.24 crore (3.42 billion)
Using this method, we have determined that the intrinsic value of XYZ Ltd’s stock is INR 342.24 crore (3.42 billion). However, this is just a theoretical value and it may not necessarily reflect the true intrinsic value of the stock. It’s important to note that the intrinsic value can be different from the current market price of the stock, in this case it’s lower than the market price.
It’s also important to keep in mind that this is just one method of intrinsic value calculation and other methods like Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio, and Dividend Discount Model (DDM) can also be used to calculate intrinsic value.