What is Intrinsic Value of Share or Stock?

Intrinsic value is the true worth of an investment. It takes into account both the physical and non-physical factors. It may be different from the current market price. It is the fair price a well-informed investor would be willing to pay based on its potential risks. Sometimes, it is also referred to as the real value of an asset. The intrinsic value of a stock is an essential factor to consider while investing in a stock. Let’s learn about it in detail.

Key Highlights

• Intrinsic value focuses on a company's long-term fundamentals, not short-term market fluctuations.

• It helps identify stocks with the potential for capital appreciation.

• Intrinsic value can be a tool for risk management and helps in avoiding overpaying for inflated stocks.

How is the intrinsic value of stocks calculated?

There are two main methods to estimate a stock's intrinsic value:

1. Discounted Cash Flow (DCF) Valuation:

This method doesn't have a single formula. Instead, it includes a series of calculations:

Forecast Future Cash Flows (FCF) per year: This is financial modelling process based on a company financials and growth projections.

Discount Rate (r): This rate reflects the risk and time value of money. It's not a set formula but can be based on factors like risk-free rate and market risk premium.

Present Value (PV) of each FCF: We can use the following formula for each year's cash flow:

Present Value = (CF1 / (1+r)^1) + (CF2 / (1+r)^2) + … + (CFn / (1+r)^n)

where, CF = cash flows r = discount rate n= time period

2. Relative Valuation

This method doesn't use a specific formula but relies on comparisons.

• Identify similar companies and their market valuation metrics (e.g., P/E Ratio).

• Analyse the target company's financial ratios.

• Based on the comparison, estimate a fair value for the target company's stock price using a similar valuation metric.

For example, if comparable companies trade at an average P/E of 20 and the target company has a P/E of 15, its stock might be undervalued. If it reaches a P/E of 20, it may have an intrinsic value closer to its price.

Example of Intrinsic Value Calculation

Let's understand the intrinsic value analysis for LMN Corporation, a leading pharmaceutical company. Suppose LMN Corporation reported a net profit of Rs. 150 crores, last fiscal year. Given the prevailing market conditions and industry standards, let's assume an appropriate Price-to-Earnings (P/E) ratio of 25 for pharmaceutical companies in India. This implies that the market value per share of LMN Corporation is Rs. 3,750 (25 x Rs. 150).

Now, projecting the future cash flows for LMN Corporation for the next decade with an estimated growth rate of 8% per annum, we can calculate the estimated net profits every year:

• Year 1: INR 162 crores (INR 150 crores x 1.08)
• Year 2: INR 174.96 crores (INR 162 crores x 1.08)
• Year 3: INR 188.95 crores (INR 174.96 crores x 1.08), and so forth.
• Year 4: INR 204.11 crores
• Year 5: INR 220.63 crores
• Year 6: INR 238.61 crores
• Year 7: INR 258.22 crores
• Year 8: INR 279.60 crores
• Year 9: INR 302.94 crores
• Year 10: INR 328.45 crores

Subsequently, applying a discount rate of 6% to these cash flows using the discounted cash flow formula, we obtain:

• Year 1: INR 152.83 crores (162/1.06)
• Year 2: INR 146.21 crores (174.96/1.062)
• Year 3: INR 139.05 crores (188.95/1.063), and so forth.
• Year 4: INR 132.33 crores
• Year 5: INR 126.02 crores
• Year 6: INR 120.11 crores
• Year 7: INR 114.58 crores
• Year 8: INR 109.41 crores
• Year 9: INR 104.56 crores
• Year 10: INR 100.02 crores

The total discounted cash flow amounts to approximately INR 1,266.28 crores. Next, we calculate the terminal value at the end of the 10th year by multiplying the projected net profit of that year by the P/E ratio. Thus, the terminal value is INR 328.45 crores x 25 = INR 8,211.25 crores.

Discounting this terminal value to its present value using the same discount rate yields approximately INR 3,989.32 crores. Finally, adding the present values of the cash flows and the terminal value, we get INR 1,266.28 crores + INR 3,989.32 crores = INR 5,255.60 crores. This analysis suggests that the intrinsic value of LMN Corporation's shares is higher than the market value, indicating potential undervaluation, which makes it an attractive investment opportunity.

Adjusting the Intrinsic Value to Account for Risk

Assessing the risk of adjusting cash flow involves subjective interpretation and quantitative analysis. There are primarily two methods for this assessment - which are as follows:

1. Discount Rate method

In the discount rate method, the analyst usually considers a company's weighted average cost of capital that includes a risk-free rate (determined from the government bond yield), a premium based on the stock's volatility, and an equity risk premium. The underlying principle is that a more volatile stock is riskier. Generally, a higher discount rate is used for such high-risk investments.

2. Certainty Rate Factor

To discount the investment, a certainty factor, or probability, can be allocated to each individual cash flow or multiplied by the business's total net present value (NPV). This strategy just uses the risk-free rate as a discount rate. This is because the cash flows have already been risk-adjusted.

Challenges with Intrinsic Value

The following are some challenges with the intrinsic value approach.

1. Subjectivity in intrinsic computing

The process of determining intrinsic value is highly subjective and involves making numerous assumptions to forecast cash flows. Consequently, any alterations in these assumptions can significantly impact the final net present value.

2. Variability in calculating weighted average cost of capital (WACC)

Computing WACC presents its own set of challenges. Factors like beta, market risk premium, etc., can be interpreted and calculated differently by different analysts. Furthermore, the subjective nature of the probability factor adds another layer of complexity to the computation.

3. Uncertainty of future

The inherent uncertainty of the future poses a significant challenge. Different investors may arrive at varying values for the same asset when using the intrinsic valuation method. This disparity arises from each investor's unique perspective on future events. Ultimately, due to the speculative nature of future outcomes, determining an accurate valuation becomes difficult.

Methods of Valuation

Three primary valuation methods are commonly used by industry professionals to find a company’s worth.

1. Comparable company analysis

This method is called trading multiples or peer group analysis. It uses relative valuation and compares the company under review to similar firms by examining P/E or EV/EBITDA ratios. By analysing these ratios, analysts can gain valuable insight into the company's value based on market comparables.

2. Precedent transactions

This method compares the target company to others in the same industry that were recently sold or acquired. It helps to understand the target company's value, similar to relative valuation. This analysis offers valuable insights into the target company's valuation and can be used to make informed decisions.

3. Discounted cash flow analysis

DCF Analysis is a popular method for intrinsic valuation. Analysts predict future cash flows, discounting them to present value using the weighted average cost of capital (WACC). For example, a company with an initial five-year cash flow of Rs.100 per annum, a 10% discount rate, and a 5% terminal growth rate can be evaluated using DCF Analysis. The value of the cash flow in 2019 is Rs.91. The value of the terminal is Rs.2100, calculated by perpetual growth. The specific method discounts the terminal value to its present value.

Conclusion

Intrinsic value is a crucial factor in investment decision-making, especially for value investors. It represents the true worth of an asset based on quantitative and qualitative factors. Although discounted cash flow analysis is common, it faces challenges like subjective interpretations and uncertain future projections. Understanding intrinsic value provides valuable insights into investment opportunities and helps investors make informed decisions amidst market uncertainties.