Intrinsic Value of a Stock: What It Is and Formulas to Calculate It

What Is the Intrinsic Value of a Stock?

Intrinsic value is a philosophical concept in which the worth of an object or endeavor is derived in and of itself, independently of other extraneous factors. Financial analysts build models to estimate what they consider to be the intrinsic value of a company's stock outside of what its perceived market price might be on any given day.

The discrepancy between market price and an analyst's estimated intrinsic value becomes a measure of investing opportunity. Those who consider such models to be reasonably good estimations of intrinsic value and who would take an investing action based on those estimations are known as value investors.

Some investors prefer to act on a hunch about the price of a stock without considering its corporate fundamentals. Others might base their purchase on the price action of the stock regardless of whether it's driven by excitement or hype. But there's another way to figure out the intrinsic value of a stock. It reduces the subjective perception of a stock's value by analyzing its fundamentals and determining its worth and how it generates cash.

Dividend Discount Models

Cash is king when you're figuring out a stock's intrinsic value. Many models calculate the fundamental value of a security factor in variables that largely pertain to cash such as dividends and future cash flows. They utilize the time value of money (TVM).

One popular model for finding a company's intrinsic value is the dividend discount model (DDM). The basic formula of the DDM is:

$\begin{aligned}&\text{Value of stock} =\frac{EDPS}{(CCE-DGR)}\\&\textbf{where:}\\&EDPS=\text{Expected dividend per share}\\&CCE=\text{Cost of capital equity}\\&DGR=\text{Dividend growth rate}\end{aligned}$​Value of stock=(CCE−DGR)EDPS​where:EDPS=Expected dividend per shareCCE=Cost of capital equityDGR=Dividend growth rate​

One variety of this dividend-based model is the Gordon Growth Model (GGM). It assumes that the company in consideration is within a steady state with growing dividends in perpetuity. It's expressed as:

$\begin{aligned} &P=\frac{D_1}{(r-g)}\\ &\textbf{where:}\\ &P=\text{Present value of stock}\\ &D_1=\text{Expected dividends one year from the present}\\ &R=\text{Required rate of return for equity investors}\\ &G=\text{Annual growth rate in dividends in perpetuity} \end{aligned}$​P=(r−g)D1​​where:P=Present value of stockD1​=Expected dividends one year from the presentR=Required rate of return for equity investorsG=Annual growth rate in dividends in perpetuity​

It accounts for the dividends that a company pays out to shareholders, as the name implies. This reflects on the company's ability to generate cash flows. There are multiple variations of this model, each of which factors in different variables depending on what assumptions you want to include. The GGM has its merits when applied to the analysis of blue-chip companies and broad indices despite its very basic and optimistic assumptions.

Residual Income Models

The residual income model is another method of calculating this value. In its simplest form, it's expressed like this:

$\begin{aligned} &V_0=BV_0+\sum\frac{RI_t}{(1+r)^t}\\ &\textbf{where:}\\ &BV_0=\text{Current book value of the company's equity}\\ &RI_t=\text{Residual income of a company at time period }t\\ &r=\text{Cost of equity} \end{aligned}$​V0​=BV0​+∑(1+r)tRIt​​where:BV0​=Current book value of the company’s equityRIt​=Residual income of a company at time period tr=Cost of equity​

The key feature of this formula lies in how its valuation method derives the value of the stock based on the difference in earnings per share and the per-share book value to arrive at the intrinsic value of the stock. Book value is the security's residual income in this case.

The model seeks to find the intrinsic value of the stock by adding its current per-share book value with its discounted residual income. This can either lessen the book value or increase it.

Discounted Cash Flow Models

The most common valuation method used to find a stock's fundamental value is the discounted cash flow (DCF) analysis. It resembles the DDM in its simplest form:

$\begin{aligned} &DCF=\frac{CF_1}{(1+r)^1}+\frac{CF_2}{(1+r)^2}+\frac{CF_3}{(1+r)^3}+\cdots\frac{CF_n}{(1+r)^n}\\ &\textbf{where:}\\ &CF_n=\text{Cash flows in period }n\\ & \begin{aligned} d=&\text{ Discount rate, Weighted Average Cost of Capital}\\ &\text{ (WACC)} \end{aligned} \end{aligned}$​DCF=(1+r)1CF1​​+(1+r)2CF2​​+(1+r)3CF3​​+⋯(1+r)nCFn​​where:CFn​=Cash flows in period nd=​ Discount rate, Weighted Average Cost of Capital (WACC)​​

You can determine a fair value for a stock based on projected future cash flows using DCF analysis. Unlike the previous two models, DCF analysis looks for free cash flows, those that exclude the non-cash expenses of the income statement such as depreciation and include spending on equipment and assets as well as changes in working capital. This model also uses WACC as a discount variable to account for the TVM.

Why Intrinsic Value Matters

Analysts employ the methods used in these models to determine whether the intrinsic value of a security is higher or lower than its current market price. This allows them to categorize it as overvalued or undervalued. Investors can typically determine an appropriate margin of safety when calculating a stock's intrinsic value in which the market price is below the estimated intrinsic value.

You can limit the amount of downside you would incur if the stock ends up being worth less than your estimate if you leave a cushion between the lower market price and the price you believe it's worth.

Suppose you find a company that you believe has strong fundamentals coupled with excellent cash flow opportunities. It trades at $10 per share in that year. After figuring out its DCF, you realize that its intrinsic value is closer to $15 per share, a bargain of $5.

You would purchase this stock at the $10 value, assuming you have a margin of safety of about 35%. You're still saving at least $2 from your initial DCF value if its intrinsic value drops by $3 a year later. You'll have ample room to sell if the share price drops with it.

Intrinsic value is a vital concept to remember when researching firms and finding bargains that fit within your investment objectives. It's not a perfect indicator of the success of a company but applying models that focus on fundamentals provides a sobering perspective on the price of its shares.

The Bottom Line

Every valuation model developed by an economist or financial academic is subject to the risk and volatility that exists in the market as well as the sheer irrationality of investors. Calculating intrinsic value may not be a guaranteed way of mitigating all losses to your portfolio but it does provide a clearer indication of a company's financial health.

Value investors and others who prefer to select investments based on business fundamentals consider this indication to be a vital component for successfully picking stocks that are intended for long-term holdings. Choosing stocks with market prices below their intrinsic value can help save money when building a portfolio.

A stock may be climbing in price in one period but it may be best to wait until the market brings it down below its intrinsic value if it appears overvalued. This not only saves you from deeper losses but it also allows for some wiggle room to allocate cash into other, more secure investment vehicles such as bonds and T-bills.

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