Intrinsic Value and Stock Selection

Posted on Thursday, September 13th, 2018 MarketBeat Staff

How much is your home worth? Before you answer that question, don’t think about the price you paid for it, and look beyond the price you would hope to get if you had to sell it today. Instead, ask yourself the question in a different way, what is your home worth to you? Because when it comes to an asset like your house, there is a difference between price and value.

We've all heard the phrase you get what you pay for but in the world of investing that's not always a good thing. Warren Buffett is credited with the phrase, "price is what you pay, and value is what you get.”

In investing this idea of getting more value than what you pay for a stock requires understanding the concept of intrinsic value. In this article we'll define intrinsic value, tell you why you can determine intrinsic value, review several popular methods for determining intrinsic value, and then explaining why you should apply a margin of safety to guard against the possibility for error in calculating the inherent value.

What is intrinsic value?

One of the most important things every investor can learn is the concept of intrinsic value. There are many definitions of intrinsic value, but when it comes to buying stock in a particular company, the concept of intrinsic value is pretty straightforward. You want to pay less for a stock than it’s actually worth.

The stock price of a company at a given point in time is called its market value. But, as any investor knows, the price the market assigns to a security does not always accurately reflect how much that stock should sell for. This perceived value is known in investing terms as intrinsic value, and it’s one of the most important concepts that investors need to understand.

At the most basic level, intrinsic value helps an investor determine whether a company’s stock is overvalued or undervalued. As an investor, you want to buy low (when a stock is undervalued) and sell high (when it is overvalued). Determining a stock’s intrinsic value is one way to do this.

Can intrinsic value be determined?

The definition of the word intrinsic means that the value is already known. Still, when it comes to determining the value of a stock, intrinsic value gives you an objective number that needs to be interpreted subjectively. Stocks don’t always behave rationally and just because a stock is overvalued doesn’t mean it doesn’t have room to grow. Likewise, sometimes a stock may be undervalued for reasons that have nothing to do with its price and may require a healthy measure of patience before it realizes its value.

How to calculate the intrinsic value of a stock

There are different calculations that are used to determine a stock's intrinsic value. When determining, or interpreting intrinsic value, it's important for investors to understand which calculation is being used. Intrinsic value is determined through fundamental analysis of a company’s financials. However, while some analysts and investors prefer to use formulas that determine intrinsic value based on the present value of a company’s future cash flows, others believe that the value can be determined and justified simply with the facts that are readily available.

Here is a summary of some of the more common methods used to establish intrinsic value:

Using a Known Financial Metric

This is the least scientific method, but many investors find it to be a valuable starting point. In this method, investors will target a specific metric such as a company’s price-to-earnings (P/E) ratio and compare it to an index such as the S&P 500. If the P/E ratio is higher than the index, the stock could be considered to be overvalued.

For example, let’s assume the average P/E ratio of all the stocks in the S&P 500 Index is 15. You’re eyeing Apple’s stock. The current P/E of Apple is just over 19. By that single metric, Apple could appear to be overvalued, and some investors might agree with that. However, that’s why it’s important to remember that this method of calculating intrinsic value is the least scientific and the most subject to interpretation.

Another popular method that uses a singular financial metric to calculate intrinsic value is the Dividend Discount Model (DDM).

Dividend Discount Model (DDM)

Because intrinsic value is a core metric used by value investors, many of the stocks that they are analyzing are dividend stocks. The DDM looks at the dollar value of dividends paid to shareholders and the projected growth rate of the dividend. To calculate the DDM you’ll need to know three things: the current dividend per share, the discount rate and the projected dividend growth rate. The formula is:

Dividend per share/ (Discount rate – Dividend growth rate)

If the DDM calculates a stock price that is higher than its current market value, the stock is viewed as overvalued. The opposite is true as well. If the calculated stock price is lower than the current market value, the stock is viewed as undervalued.

Gordon Growth Model

A variation on the Dividend Discount Model is the Gordon Growth Model. This model assumes that the dividends issued by a company will grow at a specific rate and never change. To calculate the intrinsic value using the Gordon Growth Model, you'll need to know the expected dividend per share for the following year, the rate of return you require and the assumed dividend growth rate. The formula is:

Expected dividend per share, one year from today/(Investor required rate of return – Growth rate in dividend – assumed to be the same in perpetuity)

To determine the rate of return, an investor will need to calculate the Compound Annual Growth Rate (CAGR) for the stock.

Asset-Based Valuation

Another way of calculating intrinsic value involves a relatively simple calculation that adds up a company’s tangible and intangible assets and subtracts from that its liabilities. A common formula that uses asset-based valuation is the Residual Income Formula.

Residual Income Formula

Although this formula requires some additional calculations, the theory behind it is relatively simple. Every company has a book value that is obtained by subtracting its liabilities from its assets. This is also referred to as the company's equity. To determine intrinsic value, the company uses book value as a starting point and then adds to it the residual value of anticipated earnings that the company generates in excess of a required rate of return.

To calculate the present value of future residual income, you'll need to know the required rate of return on equity, the book value, and the net income during a given period.

Residual income in future periods = Net income during a period – (required rate of return x book value)

The formula then is:

Intrinsic Value = Book Value + Present Value of Future Residual Income

Discounted Cash Flow (DCF) Method

A third way of calculating intrinsic value comes uses the time value of money along with an estimate of a company’s future cash flows. To understand the formula, you need to understand free cash flow, capital expenditures, and the weighted average cost of capital.

The DCF method is widely used by investment bankers and finance professionals. The calculations are very involved and as an investor, you can probably find a DCF from a reputable source for any given stock you're considering. For that reason, we'll leave the detailed calculations for another article. Right now, it's important to understand that the DCF method relies on assumptions and for that reason has some strengths and potential weaknesses.

Strengths of DCF analysis:

First, because of the calculations used, it is considered to be a very reliable method if you are confident in the assumptions being made, and you are very confident in future cash flow projections.

Second, because this method is based on free cash flow, it eliminates subjective accounting policies.

DCF reduces the influence of short-term market conditions or non-economic factors.

Potential weaknesses of DCF analysis

Because a DCF calculation is based on assumptions and forecasts, it can vary widely if the adjustments change just a little bit.

DCF is more time-sensitive compared to other methods for evaluating intrinsic value.

Any calculation of DCF relies on assumptions about an asset’s future performance. As any investor knows, future performance is always tricky to determine, particularly if there are concerns that the company is not being completely transparent with their information.

DCF is, by definition, a moving target. The fair value will change based on company expectations. This may be more volatile than an investor would like based on their risk tolerance.

You’ve calculated a stock’s intrinsic value, now what?

The funny thing about statistics is that we can make them say whatever we want them to say. We like to overlay our own assumptions on particular statistics to conform to our way of thinking. For example, in our earlier example with Apple, you may see a P/E ratio of 19 and although your analysis would say it’s overvalued, you buy the stock because you believe in the company and its products. That certainly seems to be the case for no less an investor than Warren Buffett who owns a significant amount of Apple stock and has quipped he would buy the whole company if he could.

However, Buffett is also famous for assigning a margin of safety when evaluating a company’s intrinsic value. Think of a margin of safety is a presumption of risk based on the assumption that a stock’s intrinsic value is based on subjective assumptions.  The margin of value is simply the percentage difference between a stock’s intrinsic value and its market value. Unlike some of the methods for calculating intrinsic value, calculating a margin of safety is easy.

If a stock is currently trading at 75 and its intrinsic value is calculated at 67.50. The margin of safety is

67.50 - 75 = -7.50 x 100% = -7.5%

But if the numbers in our example were reversed, the margin of safety turns positive.

Market value = $67.50; Intrinsic value = $75

Margin of safety = 75 – 67.50 = 7.5 x 100 = 7.5%

But what does it mean? The margin of safety sets a target price for buyers. At one time, Warren Buffett said he won’t buy a stock with a margin of safety of less than 50%. That may be a little hard to achieve in today’s investment climate, and there is no hard and fast rule. But let’s say you assign a margin of safety based on your risk tolerance of 20%. In our example, you would look for a target price of 20% above its $67.50 price ($81).

Conclusion

Knowing how to calculate the intrinsic value of a stock lets you search for the best values. If you consider yourself to be a value investor, then intrinsic value is a fundamental you will use to find stocks that you can purchase at a discount to its inherent value.

Intrinsic value is based on fundamental analysis that includes known metrics about a stock at a particular moment in time and also includes factors such as investor’s perception of the inherent value of an asset as well as assumptions about a stock’s future performance.

There are many methods that investors can use to calculate intrinsic value. No single way is considered to be the standard, and it's completely possible that two investors could arrive at two very different conclusions about the inherent value that can be completely valid based on the assumptions they make. To help smooth out the potential for error in inherent value, investors should attempt to set a margin of safety that establishes a target price based on their risk tolerance.



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