Understanding the intrinsic value of a stock and how to calculate are of paramount importance in stock trading. They help stock traders to make informed trading decisions. How so? Because intrinsic value tells traders the real value of a stock. So, traders can pick stocks for trading and investing based on their valuation.
Moreover, the calculation of the intrinsic value of a stock is complex. It is different from the market value of a stock. Therefore, it is important not to be confused here. However, you can compare the intrinsic and market value of a stock to determine whether that stock is overvalued or undervalued.
Given the importance of the intrinsic value of a stock, we decided to help you understand it in the simplest terms. We are going to define, explain, and describe how to calculate it. Let’s begin right now.
The intrinsic value of a stock – definition
The intrinsic value of a stock is a core concept in stock trading and investing. It refers to measuring the hidden value of a stock. In other words, intrinsic value means the exact worth of stocks. It is different from the market value of stock and is calculated by objective calculation. If the intrinsic value of a stock is lower than the market value, the stock is overvalued. Conversely, if the intrinsic value of a stock is higher than the market value, the stock is undervalued.
How to calculate the intrinsic value of a stock?
There is no universal approach to calculating the intrinsic value of a stock. Financial analysts use fundamental and technical analysis to calculate the actual value of stocks. That said, there are numerous worthwhile methods to calculate the intrinsic value of stocks.
1. Discounted cash flow model
Analysts often use discounted cash flow models to calculate the intrinsic value of a stock. It involves the calculation of the expected cash flow of a company. This cash flow calculation is based on the estimates of how a company may perform in the future. After cash flow calculation, they are discounted to the current value to measure the intrinsic value of a stock. Whereas, a risk-free rate of return is used as a discounted rate. Additionally, analysts may also use the weighted average cost of capital as a discounted rate. The formula is;
Discounted cash flow = Discounted cash flow 1 ÷ (1+r)^1 + Discounted cash flow 2 ÷ (1+r)^2 + Discounted cash flow 3 ÷ (1+r)^3 + … + Terminal Value ÷ (1+r)^n
r = the discount rate
Terminal value = estimated cash flow after n period
n = specific timeframe such as months, quarters, years, etc.
Let’s try to understand how to calculate the intrinsic value of a stock using discounted cash flow model formula. Suppose that the latest cash flow figure, available for investors, of a company is $200 after deducting expenditures and depreciation. We also assume that the P/E ratio of the sector is 15. Now, we can use the estimated growth rate to calculate the estimated cash flow for the next as many years as you want using the formula;
Year 1 = $200 × 7% = $214
Year 2 = ($200 × 7%)^2 = $229
And so on.
We assume that the discount rate is 3.3%. The next step is to calculate the discounted cash flow of these estimated cash flow figures using the formula;
Discounted cash flow of year 1 = (214 ÷ 1.033) = $207.16
Discounted cash flow of year 2 = (229 ÷ 1.033) = $214.6
And so on.
Finally, you can calculate the intrinsic value using the discounted cash flow model. However, you also need to estimate the terminal value. You can do so by multiplying earnings of the last year of the projection period by 15 (P/E ratio). So, you can calculate intrinsic value by adding all these figures as suggested by the formula.
2. Price-to-earnings model
Price-to-earnings model refers to the calculation of the intrinsic value of a stock using the price/earnings ratio, earnings per share (EPS), and growth rate. Whereas, the price/earnings ratio is the current ratio while EPS is the total earnings of the previous year. The price-to-earnings model formula is;
Intrinsic value based on the price-to-earnings model = EPS × (1 + r) × P/E ratio
Let’s also try to understand this formula using an example. Suppose company X reported $5.12 per share earnings of the last year. The P/E ratio is 29 and earnings are reported to be growing at a rate of 15% per year. Then the intrinsic value of the stock of that company using the price-to-earnings model is $170.
Intrinsic value = $5.12 × (1 + 0.15) × 29 = $170
3. Dividend discount model
The dividend discount model can also be used for the intrinsic value calculation but only when the company pays dividends. The formula is;
Intrinsic value based on the dividend discount model = Dividends ÷ (cost of capital equity – dividend growth rate)
The dividend in the formula refers to an expected dividend for the next period. Whereas, cost of capital equity refers to the expected returns from an asset to hold it. You can calculate it by using the following formula;
Cost of capital equity = (risk-free rate + Beta) × (required return – risk-free rate)
Again, let’s try to understand the formula using an example. Suppose company X paid $0.81 per share as a dividend. The dividend growth rate is estimated at 5%. Moreover, you also need to calculate the cost of capital equity. Therefore, suppose that the risk-free rate is 1%, the beta is 1.2, and the required return is 0.005.
Cost of capital equity = (1% + 1.2) × (5% – 1%) = 5%
We also need to calculate the expected dividend for the next period using the growth rate. It is $0.85 ($0.81 × 5%).
Now, putting all these values into the dividend discount model, we can easily calculate the intrinsic value of a stock.
Intrinsic value = $0.85 ÷ (0.05 – 5%) = $18
The intrinsic value is a key concept in stock trading. Although intrinsic value calculations are based on estimates, it gives investors a good idea about the real hidden value of stocks. As a simple rule, an intrinsic value lower than the market value indicates overvalued stocks. Whereas, an intrinsic value higher than the market value indicates undervalued stocks. Thus, investors get a good idea about the stocks they need to invest in.