Intrinsic value gives you an idea about the future cash flows of a company’s business in the present time that helps you evaluate the future potential of a stock.
Intrinsic value may or may not same as the current market price of a stock because Intrinsic value is related to the fundamentals of company business, not with market ups and downs.
Let’s discuss this in detail.
What is Intrinsic Value of Stock
The intrinsic value of a stock is the actual value that a stock worth is based on its fundamentals.
In the real world, the stock price moves up and down depending on several factors like demand supply or investor sentiments. A stock may be selling above the actual worth or it could be undervalued.
Intrinsic value helps you determine the true value of that stock to find stocks at a discount (lower price than its true potential value) for future gains.
For example, a share’s current market price is Rs.500. Its intrinsic value is Rs.400. If the stock price falls from Rs. 500 to Rs. 340 in a few months, now the stock would be trading at 15% lower of its intrinsic value making it worth buying.
How to Calculate Intrinsic Value for Indian Stocks
#1. Discount Cash Flow (DCF) Method
DCF method is the best way to calculate the intrinsic value (also called fair value) of a stock. To find intrinsic value using the DCF method, you have to perform 3 steps –
- Finding the estimated future cash flows of the company
- Calculating the present value of each of these future cash flows.
- Sum up all the present values to get the intrinsic value of the stock.
- The terminal growth rate (a constant rate at which expected free cash flows are assumed to grow indefinitely).
Cash flow is very important to an investor because you understand how a company used to pay dividends or repay debt.
Future cash flows allow you to understand how much a company will generate in the future (estimate) after spending all the expenses essential for operating the business and its growth.
Let’s understand the DCF formula to find the intrinsic value as shown below.
Intrinsic value = (CF1)/(1 + r)^1 + (CF2)/(1 + r)^2 + (CF3)/(1 + r)^3 + … + (CFn)/(1 + r)^n
- CF1 is cash flow in 1st year, CF2 is cash flow in 2nd year, and so on.
- r is the discount rate used to determine the present value of future cash flows
- n is the number of years
For example, suppose you are analyzing a company with the cash flow as below.
- Cash flow for the first five years starting 2021 – Rs 200
- Discount rate – 10%
- Terminal Growth rate – 5%
The present value of the cash flow generated in 2021 = CF / (1+r)^n
= 200/ (1+10%)^1
The present value is Rs 181
Terminal value is computed as everlasting growth.
Terminal value formula = {CF*(1+ terminal growth rate)}/(discount rate – terminal growth rate)
So, the terminal value (perpetual) is = {200*(1+5%)}/(10%-5%) = Rs 4200
Terminal value after discount in present day = TV / (1+r)^n = 4200/(1.1)5 = 2608
Now adding present values of multiple years with the terminal value to get the final intrinsic value.
= CF1 + CF2+CF3+……+TV
Intrinsic value from 2021 to 2025
= 181 + 175 + 150 + 136 +124+2608 = 3374
The intrinsic value of the stock is Rs. 3374.
Also read – Lowest PE ratio stocks in India
#2. The Ben Graham Way
You can calculate the intrinsic value of a stock using an easy method given by Benjamin Franklin in “The Intelligent Investor” book. Experts have modified that formula to use in the Indian context.
The intrinsic value formula is –
V = EPS x (8.5 +2g) x 8.5/Y
- V = Intrinsic Value.
- EPS = Earning Per Share.
- 8.5 = Assumed intrinsic P/E ratio of Stock.
- g = Assumed future growth rate (7-10 years)
- Y = Interest Rate of AAA Corporate Bonds in India on today
For example, let’s calculate the intrinsic value of the ITC share.
- Current share price – Rs. 200 (approx)
- EPS as per records – Rs. 10.55
- Expected future growth rate – 10%
- Corporate bond interest rate – 7%
The Intrinsic value of ITC share = 10.55 x (8.5 + 2(10/100)) x 8.5/7 = 111.45
However, you have to understand other factors like the company’s management, debt to equity ratio, PE ratio to know if actually, a stock is valuable or not.
Check out – Equity share vs Preference share
Benefits of Calculating Intrinsic Value of Stock
- Helps in estimating the futuristic value of company stock
- To understand the potential profitability or loss-making risk of a stock before buying
You may like to read – Best value investing books
Final Words
You have learned several methods like the DCF (Discounted cash flow) Method or Ben graham way to find the intrinsic value of a stock.
Go with what you feel easy for your calculations.
Along with finding the intrinsic value, you can also learn other terms like Bonus shares, Price-to-book ratio (P/B ratio), Book value per share (BVPS), and Price to earnings ratio (P/E ratio) for a more in-depth analysis of a stock price before buying.