What is Intrinsic Value? Your guide to describing an asset’s true or perceived worth
Investors are always looking for methods to determine whether an asset is worth acquiring at its current market price. Overpaying for a stock can lead to losses or reduced profits, while hesitancy in buying an undervalued stock can result in a missed opportunity.
Value investors have long looked at the intrinsic value of an asset to determine whether it’s worth investing in. Calculating intrinsic value requires complex quantitative assessment and in-depth understanding of an asset.
What is intrinsic value? In this article we have compiled useful information to help you understand intrinsic value meaning and learn how to calculate it.
What is intrinsic value?
Intrinsic value is the measure of an asset’s worth based on objective calculations or a financial model.
What is the meaning of intrinsic value in the investing world? For investors, the main objective of calculating an asset’s intrinsic value is to determine whether it’s undervalued or overvalued at the current market price.
Intrinsic value metrics were popularised by the school of value investing and have now become a common part of fundamental analysis of stocks, bonds and option contracts.
In his book Security Analysis, Benjamin Graham, widely known as the “father of value investing”, defined intrinsic value as “that value which is justified by the facts”, such as earnings, dividends and definite prospects, as cited by investment research firm Morningstar, which notes:
How to calculate intrinsic value?
Before we get into the details of an intrinsic value definition and various intrinsic value calculator formulas, it is important to note that there is no universal standard or a perfect way to calculate an asset’s intrinsic value.
A stock’s intrinsic value is gauged by the company’s cash flow. It measures the value or worth of a stock based on analysis of the company’s financial performance. This is different from the market value of a stock, which is the price market participants are willing to pay for it at any moment.
One of the most popular methods of calculating intrinsic value is by the discounted cash flow (DCF) method.
According to DCF, the worth of a stock is equal to the present value of its expected future cash flows minus a discounted rate that reflects the risk and uncertainties that come with the investment.
Here there are many assumptions used, including the company’s expected future sales growth and its estimated future profit margins.
In order to arrive at an accurate measure of a stock’s intrinsic value, investors need an in-depth understanding of the company’s financial performance, business model, governance, operating market, competition and industry trends.
Fleck explained that investors should be “cautious of extrapolating the past not the future” and that looking into a company’s competitors can help determine how much larger profit margins can get.
Fleck added that Morningstar analysts use a weighted average cost of capital, which accounts for a company’s cost of equity and its cost of debt, to determine at rate at which future cash flows should be discounted.
What is intrinsic value formula?
The formula for discounted cash flow is as follows:
DCF = CF1/(1+r)^1 + CF2/(1+r)^2 + CFn/(1+r)^n
Where CF1 = Cash flow for year one
CF2 = Cash flow for year two
CFn= Cash flow for additional years
r = Discount rate
What is an intrinsic value example use case? Let’s say that ABC stock is trading at $100. After determining the variables needed for the DCF formula we arrive at the intrinsic value of $120. It can be concluded that the stock is undervalued and an attractive buy.
Limitations of intrinsic value
Using intrinsic value as the go-to metric in an investment has its limitations and drawbacks.
Intrinsic value is a theoretical number that depends on variables that can differ among analysts based on their calculations.
Intrinsic value models such as DCF are sensitive to small changes in assumptions of future earnings and discount rates, according to Morgan Stanley.
There are concerns about DCF models being poorly calculated and having errors related to theory and dubious economic judgements.
The DCF model is limited when calculating the intrinsic value of loss-making companies. According to Morgan Stanley, about 40% of public companies in the US had negative net income in 2020.
Alternative valuation methods like price-to-earnings (P/E), price-to-book (P/B), and enterprise value-to-earnings before interest, taxes, depreciation, and amortisation (EBITDA) have become more popular among investors due to their ease of use.
Financial markets are largely influenced by human emotions which can result in exaggerated rise and fall in the price of an asset. There is no guarantee that a stock price will rise above or trade at the intrinsic value as determined by the investor.
The bottom line
Intrinsic value is a useful method for investors when trying to understand a stock’ worth. While there is no perfect valuation method, the process of understanding intrinsic value meaning gives investors an in-depth knowledge about the prospective stocks and its future cash flows.
Financial markets are unpredictable. It is very important to acknowledge the risks involved in investing. Always conduct your own due diligence. And never risk more money than you can afford to lose.
FAQs
What is an example of intrinsic value?
Intrinsic value helps investors determine whether a stock is undervalued or overvalued at its current market price. If an investor calculates the ABC stock’s intrinsic value to be $100 when it is trading at $50, the investor can conclude that ABC is currently undervalued.
How do I calculate intrinsic value?
The discounted cash flow (DCF) model is one of the most popular methods for calculating an asset's intrinsic value.
What is the difference between intrinsic value and market value?
A stock’s intrinsic value is calculated based on the company’s cash flows. It measures the value or worth of a stock based on the company’s financial performance. This is different from the market value of a stock, which is the price market participants are willing to pay for it at that moment.
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