Learn How To Calculate The Intrinsic Value of Investments

Introduction

Berkshire Hathaway CEO Warren Buffett has rightly said: "Never invest in a business you cannot understand."

Do you know the intrinsic value meaning and how the value of your investment is calculated? Many rely on the markets depending on what investors are currently willing to pay for stocks or corporate bonds. However, value investors prefer a more reliable measure of calculating the actual value of an investment – through its intrinsic value.

What is intrinsic value of stock? - The Intrinsic value of a stock is the Net Asset Value that can provide a deeper value to investment and is a fundamental concept that investors use to discover unknown investment opportunities. The DCF, or the Discounted Cash Flow analysis, is used for many intrinsic value calculations. When the market price of an asset is lower than its net asset value, it can be a wise investment.
 

What Is Intrinsic Value?

Intrinsic value meaning -

The inherent value of an investment is the current price minus the strike price of an asset. It measures the importance of an asset that differs from its market price and can give you an idea of whether the investment is undervalued or overvalued.

Intrinsic value is calculated based on cash flows showing the asset's value based on an analysis of its actual financial performance. The most critical measure is Discounted Cash Flow (DCF). DCF is the current value of expected cash flows, discounted at a rate considering the risk associated with the investment. It is crucial to find out estimated future cash flows while using DCF.

It reveals higher values of assets resulting from lower discount rates and higher forecasted cash flows. Many analysts use different cash flows and discount rates that reflect the uncertainties in estimating future performance. Calculating the intrinsic value of stock became in range since the 1950s when Warren Buffet started practicing it.
 

How To Calculate The Intrinsic Value?

To determine the intrinsic value of shares or the current value of any investment, whether real estate, stocks, shares, or long-term assets, you can use the DCF method to calculate its Intrinsic Value. Let us see the formula:

What is Intrinsic value of stock?

You need three inputs for Intrinsic Value calculations:

●  Estimated future cash flows
●  The discount rate is used to analyze the current value of future cash flows.
●  A method of valuing the business is called the terminal value.

 Here is the formula to calculate the intrinsic value of stocks:

●  DCF: Discounted cash flow or current inherent value of the company.
●  CF: cash flow in years one, two, etc.
●  TV: final value.
●   R: The discount rate.

How to Trade Index Futures?

Let us learn about the 3 ways which can be used to trade index futures:

Estimated Future Cash Flows

●   You can estimate a company's future cash flows by considering its past data, i.e., cash flows for the past 12 months. Then use the method to calculate a specific growth rate to project forecasted cash flows based on past performance. The assumed growth rate must consider even the slightest price changes, as these have a critical impact on the rating. However, you must be careful in calculating the intrinsic value based on this method as it may be expected, especially in the case of a faster-developing business, that it will grow at above-average rates for an extended period.

Terminal Value

●   After estimating cash flows for 10-20 years, DCF considers the terminal value, calculated depending on the previous year's multiples of the cash flows. You can use a single multiple or a range of multiples to calculate. Also, this multiple can be the average multiple of the rating company or a multiple based on industry data. Although this is not the only way to calculate the value, it is quite an easy and convenient method.

●   Discount Rate

The intrinsic value is inversely proportional to the discount rate. But to consider the same, you must be wary about today's historically low rates; you should be careful. For example, there could be a Government bond yield of 1.30% in 2020, whereas historically, it gave an average of 5% and as high as 15% in the past years. Several analysts adjust the high discount rate to reflect the company's risk, and many use a discount rate range, just like a growth rate range.
 

Intrinsic value Example Explanation

Example

Let us assume the disposable income for investors of XYZ company as cash flow at Rs. 100 (after adding depreciation and deducting capital expenses) for the last year. If a hypothetical P/E multiple for the S&P 500 is 30, the market value per share of XYZ company is Rs. 3,000 (30 x 100). We use that figure for comparison with the intrinsic value of shares.

Assuming an estimated growth of 5%, the estimated cash flow for each of the 10 years is:

Year 1: Rs. 105.00 (100 x 1.05)
Year 2: Rs. 110.25 (100 x 1.052)
Year 3: Rs. 115.76 (100 x 1.053)and so on
Year 4: Rs. 121.55
Year 5: Rs. 127.63
Year 6: Rs. 134
Year 7: Rs. 140.71
Year 8: Rs. 147.74
Year 9: Rs. 155.13
Year 10: Rs. 162.89

We then discount these cash flows using a yield of 2% and use the formula CF/1 + r. The discounted cash flow for each of the 10 years is:

Year 1: Rs. 102.94 (105/1.02)
Year 2: Rs. 105.97 (110.25/1.022)
Year 3: Rs. 109.08 (115.76/1.023 etc.)
Year 4: Rs. 112.29
Year 5: Rs. 115.60
6th year: Rs. 118.99
7th year: Rs. 122.50
Year 8: Rs. 125.89
Year 9: Rs. 129.80
Year 10: Rs. 133.62

The total discounted cash flow is Rs. 1176.68.

Next, the final year projection should be multiplied by the P/E multiple of 30, That's 162.89 x 30 = Rs. 4886.7.

The discounted amount is

Rs. 4008.79 (4886.7/ 1.0210).

Finally, both the discounted values should be added – for the first 10 years of discounted cash flows and the 10 years of the terminal cash flow for the net asset value:

1176.68 + 4008.79 = 5185.48

This shows that the intrinsic value of share is undervalued and can be considered an investment.
 

Examples of Index Futures pointers explained (Owner Earnings, Growth Rate with table representation, Discount Rate, Terminal Value)

Let's look at a hypothetical example to understand intrinsic value better.

Owner Earnings

The owner's income is calculated by:

Net income + depreciation - capital expenditures.

Net income is a part of a company's income statement, while depreciation and capital expenditures are a part of the cash flow statement.

Let us assume that the profits of the owners of XYZ company at the end of the previous year were Rs. 100 per share.

The current S&P 500 price-earnings ratio is around 30. We use this multiple to assume that XYZ trades at 3000 per share (100 x 30). The question now is whether the company is overvalued or undervalued.

Growth Rate

Let's assume that the business increased the owner's earnings by 10% per year.

We assume that the growth rate will remain at 10% for the next 10 years. We also calculate intrinsic value assuming a lower growth rate of 5%. This will help emphasize the importance of the growth hypothesis.

With these assumptions, we can predict the owner's income for the next 10 years. The formula for owner profit at the end of the first year, assuming a growth rate of 5%, is the owner's current profit (100 per share) multiplied by 1 plus the growth rate, which is 1.05. In year 2, the 100 per shareholder earrings are multiplied by 1.05 ^ 2 to reflect the growth.

Here are the results:

As you can see, a difference of up to 5% in the growth rate assumption considerably impacts the resulting growth in the owner's income.

Discount Rate

Now you would need to calculate the present value of that income.

As with the growth rate hypothesis, it is important to remember that small changes in the discount rate can significantly affect the net asset value. The formula for discounting year-end income (105 with a growth rate of 5%) at a discount rate of 2% would be 105/1.02^

Using this formula for each year and growth assumptions, you can now compare the numbers at a discount rate of 6%, which reflects a more normal return on a long-term investment:

It is generally best to take a conservative approach and raise the discount rate to reflect a more normalized interest rate environment. For this reason, we will use the discount rate of 6% in the future.

Terminal Value

For the terminal value, we use a simple approach by multiplying the owner's income at the end of the year 10 by a P/E multiple of 30. The discount rate will be 6%

After multiplying last year's owner's income by 30, we get the following discounted values using our discount rate of 6%

162.89 x 30/1.06^10 - 5% growth rate =
259.37 x 30/1.06^10 - 10% growth rate = 2,172.50

Now we can arrive at the company's Intrinsic Value by calculating the same for 10 years and comparing it with the current share price of 3000; we can conclude that the company is overvalued at a growth rate of 5% but undervalued at a growth rate of 10%.

The Limitations Of Intrinsic Value

Intrinsic value calculation of assets has its disadvantages as well. Investments that do not possess cash flows cannot have their inherent value determined. For example, gold, silver, or even cryptocurrencies. Similarly, some businesses that are either start-ups or highly volatile companies in highly competitive markets can find it too difficult to get an intrinsic value calculation.

Since Intrinsic value attempts to measure the value of an asset based on future cash flows, it can differ significantly from a company's stock price. It is not the only way, but the intrinsic value is one of the highly utilized and most convenient ways of analyzing the value of an investment, which value-oriented investors use.
 

Conclusion

Investors must understand how to calculate the value of an investment using its intrinsic value. The best feature about relying on this value is that it determines the actual value of an investment considering future cash flows and not just where an asset is currently trading. Value investors can measure using the value whether the asset's price is priced correctly or not based on their investment approach.