Have a hard time to find what is intrinsic value of stock? In short, intrinsic value is the actual value of a company. It may or may not be the same as the current market value. It is also a measure of asset value which covers all the intangible and tangible aspects of the business as well.
Find what is intrinsic value of stock is the key in value investing. And the fact is it is not easy to derive its actual value. Warren Buffett had mentioned the importance of determining intrinsic value is to see if a good stock is undervalued for purchase. However, he didnt specifically give out his clear method of calculating the intrinsic value of stock.
His mentor, Prof Benjamin Graham could be the first person in identifying or publicising the importance of finding this value. He published his famous book called the Security Analysis (1951 edition) :
“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value.”
“A general definition of intrinsic value would be that value which is justified by the facts—e.g., assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor.”
Personally, i find it is a bit hard to have the patience in reading Security Analysis. It has a lot of technical jargons. If you need a more simpler book, I strongly recommend “The Intelligent Investor“.
What Is Intrinsic Value of Stock
Many people use discounted cash flow (DCF) model as an valuation method used to determine what is intrinsic value of a company. It takes into account a company’s free cash flow and weighted average cost of capital.
With reference from Wikipedia, I included the discounted cash flow formula in this post. You may derive DCF by using the future value formula for calculating the time value of money and compounding returns.
The below formula expresses the discounted present value (for one cash flow in one future period):
- DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;
- FV is the nominal value of a cash flow amount in a future period;
- r refers to the interest rate or discount rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;
- n refers to the time in years before the future cash flow occurs.
Does the above explanation easy to understand? I bet you confuse over the above definition or the mathematical formula. It is not a surprise to me. I went through the same.
To conclude, finding what is intrinsic value is an art. People may use different valuation methods in attempt to derive this value. It is not just about net income. In addition, we need to consider depreciation, changes in working capital, operating cashflow and so on. Warren Buffett once said that “intrinsic value is an estimate figure.” Therefore, you need not be overly stressed to find out its exact value.
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Fundamental Analysis Lesson #2