Intrinsic value determines the worth of an asset by calculating its current value of all anticipated future cash flows. This only considers the inherent value of a business rather than comparing companies. In other words, intrinsic value is a price that the investors are willing to pay for an asset.
IV= (F1/(i+1)^1) + (F2/(i+1)^2) + (F3/(i+1)^3) + ….. + (Fn/(i+n)^n)
Where, Fx = cash flow per year
i = annual interest rate
n = total number of periods included
ANALYSIS BASED ON FINANCIAL METRIC
Using a financial metric is also an easy way to calculate the intrinsic value of a stock. Here, lets see the formula for intrinsic value using P/E ratio.
IV = EPS x (i+1) x P/E ratio
Where, EPS = Earnings Per Share
i = expected earnings growth rate
RISK ADJUSTING THE INTRINSIC VALUE
Particularly, there are two main methods:
- Discount Rate
In this method, an analyst significantly uses a company’s WACC( Weighted Average Cost of Capital). WACC generally include a risk-free rate in addition to a premium based upon a stock’s volatility multiplied by an equity risk premium. The fundamental theory behind this approach is that if a stock is more volatile, it involves a riskier investment. Consequently, a higher discount rate is used to reduce the value of cashflow in the future.
- Certainty Factor
In this, a certainty factor or probability is specifically assigned to the individual cash flows or the total NPV( Net Present Value ). This serves as a means of discounting the investment. As the cash flows are risk-adjusted, only the risk-free rate is used as the discount rate.
DIFFICULTIES WITH INTRINSIC VALUE
Formerly, calculation of intrinsic value is a highly subjective practice. This consists of various assumptions for the cash flow projection. Therefore, the final NPV totally depends on these assumptions and can change with respect to these.
Another thing is that we can calculate the WACC factors, market risk premium, beta separately. But, the certainty factor or probability is completely subjective.
Finally, the future is always unpredictable. Different investors have different way of looking at the future. Therefore, no numbers are accurate enough.
There are three main methods for valuing a company.
- Comparable Analysis
This method considers a relative valuation in which an analyst compares the asset with similar securities by analyzing trading multiples or other ratios.
- Precedent Transactions
This is similar to comparable analysis. In this, an analyst compares the asset with recently transacted ones or with others in the same industry.
- DCF Analysis
Discounted Cash Flow is the most widely used method for intrinsic value. In this, the analyst predicts the future cash flow and discount it to the current value using WACC.
In conclusion, intrinsic value is a crucial factor in valuing a company for investment. Investors can identify the best method from several to use for their own purposes.