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So, what is the intrinsic value of a stock?
And how do you actually calculate the intrinsic value of a stock?
If you are a value investor, you know that Warren Buffet actually uses the intrinsic value to help him make investment decisions.
Later on, we will also look at exactly how Warren Buffet calculates the intrinsic value of a stock.
What Is The Intrinsic Value Of A Stock?
So, what is the intrinsic value of a stock?
And why is it so important?
The intrinsic value of a stock refers to the fundamental and objective value of the company that issues the stock.
Essentially, you are trying to determine the fundamental value of the company (or its business).
There are many different ways to value a company (i.e. value a stock).
Now, let’s take a look at them one by one.
Warren Buffet’s Method To Calculate Intrinsic Value Of A Stock
First, let’s look at how Warren Buffet calculates the intrinsic value of a stock.
To find the estimated intrinsic value of a business, Warren Buffet always prefers to look at its cash flow.
That means how much cash the business is generating.
This is because it is much more difficult to manipulate cash flow than, for example, revenue or net income.
So, you will get a more accurate valuation of the business when you use cashflow data.
Now, how exactly do you calculate the intrinsic value of a stock using cashflow?
First, you need to estimate the future cash flow for the next 10 years at least. ( ideally, the number of years should be as long as you expect the business to be still around)
Then, you need to calculate the present value of all the future cash flows.
Why do you need to find the present value?
Why not just add up all the future cash flows?
This is because you are trying to value the stock at the present time.
Also, future money is NOT equal to present money.
Generally, $100 today is worth more than $100 in the future.
If you put $100 today in a high yield money market account, it will earn interest for you over the years.
So, you will get more than $100 in the future when you decide to withdraw it.
Now, let’s go back to the intrinsic value calculation.
How do you determine the present value of all the future cash flows?
You do that by discounting each of the future cash flows at an appropriate discount rate.
In the case of valuing a stock, you don’t just use the risk-free interest rate you earn from your savings account or government bond.
This discount rate is usually a risk-free rate (usually a government bond yield) plus a risk premium.
Why a risk premium?
This is because stocks are more volatile and risky than government bonds.
By adding a risk premium, you get a higher discount rate.
A higher discount rate will reduce the present value of all the future cash flow to reflect the risks involved in investing in the stock.
Now, if you put everything in a formula, here will be what the intrinsic value formula looks like:
Intrinsic Value Formula
“FV” refers to future cash flow.
“n” refers to the number of time periods (i.e. Year 1, Year 2, Year 3, …)
“i” refers to the discount rate.
Calculate The Intrinsic Value Of A Stock Using Stock Rover
Here’s a much easier way to calculate the intrinsic value of a stock using Stock Rover.
Stock Rover is a very powerful stock research and analysis platform that is specifically designed to help you with fundamental analysis.
It provides over 650 metrics (i.e. financial, fundamental, valuation, growth, ratings, technical, etc)
To put it in perspective for you, the FREE stock screeners you can easily find online provides you with much much fewer metrics (i.e. less than 100).
What’s more, Stock Rover also provides advanced metrics such as the Fair Value and Margin of Safety.
So, you don’t have to manually calculate the intrinsic value of the stock anymore.
With just a simple click, you will have the intrinsic value of any US stock or Canadian stock in front of you.
This saves you tons of time and makes your stock research and analysis more efficient.
So, how do you use intrinsic value to find good stocks?
To do that, you first need to understand the difference between intrinsic value and market value.
Market value is the current price at which investors are willing to transact the shares of the stock.
You see, the current share price might NOT reflect the intrinsic value of the stock because of a lot of factors.
One example is panic selling due to, let’s say, the coronavirus crisis or economic crisis.
When investors do panic selling, they irrationally sell down the stock even if the business is little affected by the crisis and still generates more or less the same amount of profits.
Another example is the short term bad company news that doesn’t affect the long-term outlook of the company.
When this happens, the stock price goes down even below the intrinsic value of the company.
So, what do you do when the stock’s intrinsic value is more than its current market value?
That’s a great investment opportunity for you.
Because it means the stock is undervalued.
I’ve been using Stock Rover to find undervalued stocks because it has everything I need to do my fundamental analysis on stocks.
Now, what about intrinsic value vs book value?
Is intrinsic value the same as book value?
Book value refers to the value of a business according to its financial statements.
So, what does this mean?
Basically, when you sell all the assets that the company owns right now and then pay back all the debts it owes.
Whatever money that is left is the book value of the company.
So, book value does not take into account all the future value the business can generate.
I sort of view book value as the minimum value of a company.
In other words, the stock of the company should be worth at least the book value today.
Generally speaking, if the business is expected to post any positive earnings in the future, its intrinsic value would be greater than its book value.
Personally, I use Stock Rover to create a watch list of stocks that have book value that is equal to 1.5 or less.
This is another way to find potentially undervalued stocks to invest in.
Other Ways To Calculate Intrinsic Value Of A Stock
Of course, there are also other methods to calculate the intrinsic value of a stock.
In a way, it’s kind of similar to the discounted cash flow method that we discussed earlier.
So, what do I mean by that?
Instead of using future cash flow to determine the present value of the company, you can use other financial metrics to do it.
Here are the other two other metrics that you can use:
- Residue Income
Discounted Dividend Method
So, why dividends?
Dividends are the amount of money that a company pays out to its shareholders.
It indicates how well the company can generate profits from its business operations.
Now, how do you use the discounted dividend method to calculate the intrinsic value of a stock?
First, you estimate the expected dividend per share.
Next, you calculate the cost of capital as well as estimate the dividend growth rate.
Lastly, you calculate the intrinsic value of the stock by discounting the expected dividend per share by the difference between the cost of capital and the dividend growth rate.
This is the formula to calculate the intrinsic value of a stock using the discounted dividend method:
Discounted Residue Income Method
Another way to calculate the intrinsic value of a stock is to use the discounted residue income method.
So, what is residue income?
Residue income refers to the net income after deducting all the costs of capital required to producing that income.
How do you calculate the intrinsic value using the discounted residue income?
First, you estimate all the future residue income.
Next, you determine the present value of all these future residue income.
Lastly, you add this to the current book value of the company to arrive at the intrinsic value.
This is the formula to calculate the intrinsic value of a stock using discounted residue income method:
Drawbacks of Intrinsic Value Calculation Methods
Although there are different ways to calculate the intrinsic value of a stock, there is one thing that you should be aware of.
These methods are just used to ESTIMATE the intrinsic value of a stock.
It’s NOT 100% accurate because there are just a lot of subjective assumptions used in the calculations.
For example, you have to make assumptions about the projected future cash flow as well as its growth rate in the discounted cash flow method.
Having said that, it’s still a good way to help you determine whether a stock is worth investing in at the current market price.