What is Intrinsic Value?
Intrinsic Value is the estimated worth of an asset following the objective analysis of its fundamentals and internal financial data, without reliance on external factors such as prevailing market pricing.
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How to Calculate Intrinsic Value of Stock?
The premise of intrinsic value states that how much an asset is worth can be derived from assessing the asset internally.
For instance, a company’s share price can be approximated by assessing the underlying fundamentals:
- Revenue → Historical Trends, Key Drivers of Revenue, Future Growth Outlook
- Margin Profile → Historical Profit Margins (e.g. Gross Margin, Operating Margin, EBITDA Margin, Net Profit Margin), Opportunities for Cost-Cutting, Industry Averages, Future Spending Needs
- Competitive Advantage → “Economic Moat”, Competitive Landscape, Market Size, and Market Share
In the context of corporate valuation, the intrinsic value of a company is estimated from its future cash flows, growth potential, and risk. Thus, the foundation of a DCF valuation model is the 3-statement financial model.
Intrinsic Value Formula
The formula for calculating the intrinsic value states the asset’s estimated worth is a function of its future cash flows, which must be discounted to the present date.
The expected cash flows of the asset are each discounted, and the sum of those cash flows represents the asset’s intrinsic value.
Where:
- CF = Future Cash Flows
- r = Discount Rate (WACC or Cost of Equity)
- t = Time Period
Intrinsic Value Method: Discounted Cash Flow (DCF) Model
The discounted cash flow model (DCF) approach calculates the present value (PV) of the company’s expected cash flows (i.e. discounted to the present date), which is the estimated value of the company.
Here, all the future cash flows (CF) of the company are discounted using an appropriate discount rate (r) that risk factors – and then adds all the discounted cash flows together.
Therefore, the intrinsic valuation is a function of future free cash flows – either FCFF or FCFE – expected to be generated by the company’s operations.
Each DCF model relies significantly on discretionary assumptions.
While all assumptions are subjective, if the model assumptions are completely baseless, the estimated value of the company will be far off from its intrinsic value.
- Intrinsic Value of Stock > Current Share Price → Undervalued – Potential Buy
- Intrinsic Value of Stock = Current Share Price → “Correct” Market Pricing
- Intrinsic Value of Stock < Current Share Price → Overvalued – Potential Short-Sell
Intrinsic Value DCF Model Example
Intrinsic Value Method: Dividend Discount Model (DDM)
Another intrinsic valuation method is the dividend discount model (DDM), although the DDM is not used as frequently as the DCF.
The dividend discount model (DDM) values a company based on the present value (PV) of its future dividends, with assumptions regarding the dividend amount and growth rate.
The intuition behind the DDM is similar to the DCF, however, the major difference is that dividends are used as cash flows.
Under the DDM, dividends issued by a company are assumed to be representative of the company’s financial health and future outlook.
The intrinsic value – considering how the obtained valuation is largely independent of market pricing – can uncover undervalued investment opportunities for investors to profit from the mispricing.
