A stock, as we all know, is a share of a company’s capital. You become a part-owner of the corporation if you own one. As far as you or the analyst are concerned, the inherent value is its fair worth.
Here’s a simple illustration to help you grasp how to calculate intrinsic value. Let’s imagine you wish to buy a house with the intention of renting it out. This qualifies it as an investment since you anticipate future cash flows or profits. Let’s say you wish to keep it for ten years. You’d only acquire it if delivers a larger total cash flow than what you’re paying now. Future cash flows and the house’s resale value can be modified for inflation and various risks to ensure accuracy.
In other words, you’ll only want to pay a price that’s less than the house’s cumulative rent over ten years plus its selling worth. Otherwise, purchasing a home is a waste of money. As a result, you would perform specific calculations to determine the fair price that you would be willing to pay for the residence in order to reap the benefits. That’s a simple concept to grasp. But how do you determine a stock’s estimated future income? It’s also straightforward.
How to calculate intrinsic value?
1. Dividend Discount Model
Calculating the intrinsic value of a stock is often done using the DDM. The dividend discount model, abbreviated as DDM, forecasts a stock’s price based on the current value of its future dividend payments. The intrinsic value formula is basically that it takes the sum of all future dividends expected to be paid by a corporation and discounts them to arrive at their current worth. The stock is undervalued if the DDM price is higher than the current value, and it is overpriced if the DDM price is lower. However, you may not acquire a stock if you believe it is highly overvalued. If, on the other hand, you believe the stock is greatly undervalued, it could be an excellent investment.
2. Discounted cash flow analysis
The discounted cash flow, abbreviated as DCF, is a method for determining the value of an investment or a stock based on the free cash flows that the company is likely to generate in the future. The intrinsic value formula involves using a discount rate, and these future cash flows are discounted to arrive at their present value. “A rupee earned today is better than a rupee earned tomorrow”, according to the discounted cash flow analysis. The reasoning is straightforward. You can improve the value of the rupee you have in your palm today by investing it. That is, after all, what investment is all about.
3. Relative Valuation method
This method compares a stock’s price to the company’s fundamentals, such as revenue, net income, profits, and equity share book value. When you purchase a stock, you become a part-owner of the corporation that issued it. As a result, you own a fraction of these essentials as well.
The price to earnings (PE) ratio is one of the most important ratios to consider when performing relative value analysis. The PE ratio will be Rs 10 if the stock price is Rs 1000 and the company’s earnings per share are Rs 100.
This means you pay Rs 10 for every rupee earned by the company. Compare this price to the PE ratio of the company’s peers to see if it is reasonable. If the company’s PE ratio is lower than its competitors’ average PE, you can get the shares for a lesser price, and vice versa.
Is it true that all stocks trade at a premium to their intrinsic value?
Not every stock trades at a premium to its intrinsic worth. Some may be trading at the same level as it, if not lower. When you acquire a company at its intrinsic value or a price below it, you have a better chance of making a greater profit. It’s essentially a no-brainer: lower the purchase price, higher the profit; higher the purchase price, lower the profit, as long as the selling price or final value of the investment in question remains constant. The significance of such equities is that they have a greater proclivity to rise in the future. This can occur in two stages:
For starters, the market recognizes that this stock is undervalued. As a result, there will be more buyers than sellers, and the price will begin to rise and will continue to do so until it reaches the intrinsic worth. Second, the price exceeds the inherent value, maintaining the upward trend. As a result, the stock becomes overvalued.
You may now understand how to calculate the intrinsic value of a stock and how it can assist you in making a well-informed investing decision. However, be aware that, despite its widespread usage, stock intrinsic value research is criticized since it relies on numerous assumptions. Nonetheless, this can be an excellent place to start when analyzing a stock before purchasing it.
Calculating the intrinsic value of a stock is an essential step in becoming a successful fundamental investor in the Indian stock market. FinLearn Academy’s course on ‘How to Calculate Intrinsic Value’ is a comprehensive guide for all your investing needs.