What is Intrinsic Value of a Stock?

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Many a time it happens that the market price of a particular stock does not represent the true value of the company. Thus analysts use intrinsic value to determine if a stock’s price undervalues the business. 

In layman terms, they are estimating the 'fair value' or 'intrinsic value' of the stock.

But why so much stress on Intrinsic value?

Why rack your brain with so much complex calculation?

Why not simply buying the share on market value?

Because stocks will be profitable only if you buy them at a discounted price. 

Did I just mention 'Discounted'?

Well, the investment guru of all times, I'm definitely not talking about Warren Buffet, Benjamin Graham  (Guru to Warren Buffett) says that stocks must be bought at a ‘discount‘ to its intrinsic value.


What means by discount?

Suppose a stock’s market price is Rs.100. Upon estimation, its intrinsic value comes out to be Rs.90. But due to company's management issues or losses or due to another temporary the market price of this stock currently fell from Rs.100 to Rs.80.

At this price level, the stock is said to be trading at a discount of 11.1% to its intrinsic value [(90-80)/90].

MARKET PRICE

Market price is the price in which the stock is currently trading in the stock market. It is the price where one can buy or sell the stock. Even Warren Buffet has to buy stocks at this market price if he intends to. There is no partiality here.

Then how did Warren Buffet make so many assets?

What is the difference between his investing and that of ours?

Warren Buffett will never buy a stock without knowing its intrinsic value. 

Why? 

Because he buys only those stocks that are available at a discount to its intrinsic value
[Market Price less than Intrinsic Value].


INTRINSIC VALUE

Warren Buffet focuses on buys stocks at less than its intrinsic value. Such stocks are called 'Undervalued Stocks'.

But what's the damn benefit of buying an undervalued stock?

There is a high possibility that the prices of such stocks have stronger tendencies to move-up over time and give away good returns of course creating greater value.

How is the possibility so high, that the stock price 'WILL' definitely rise?

When the market recognizes that the current stock price of a stock is undervalued. In such a case, there will be automatic traffic drawn, and hence more buyers for this stock than its sellers. 

Hence its price will start moving up slowly. This is like a certain logical growth. 

This upward price momentum will continue till market price equals the intrinsic value. By this time this stock would be in news headlines, trending across portfolios and thereby achieving higher highs.

This is when the stock starts becoming overvalued.

INTRINSIC VALUE FORMULA

Benjamin Graham is the brains behind the 'intrinsic value formula'. He was a professor at Colombia University and one of the most influential investors in history.
This was the first version of the derived formula found in the book "The Intelligent Investor".

where,

EPS = Earning per share
8.5  = The constant represents the appropriate PE ratio for a non-growth company proposed by Graham
g     = The company's long term growth estimate

A few years later, in 1962, Graham modified the original formula for future ease. 
He introduced a 'multiplying factor' further called 'Intrest Rate Factor' and then the formula has a new look, 

where,

4.4 = Interest Rate for AAA Corporate Bond in USA in the year 1962
Y    = Interest Rate for AAA Corporate Bond in USA Today
and
(4.4/Y) = Interest Rate Ratio

INTRINSIC VALUE FORMULA FOR INDIA

But there is a slight limitation while applying this formula,

Why?

In the above formula, there is a factor '4.4', this formula with this factor is suitable only for stocks trading in the American Stock exchange.

Right?

So there must be some different factors for stocks trading in the Indian exchange.

Right?

Why?

Because in the denominator there is a factor 'Y'. And now that we know what is Y, we also need to alter the value of the numerator.

When I started to research different formulas for stock analysis, I couldn't find the perfect substitution which would fit the shoes of corporate bonds in India.

So, I thought of using assumptions to reconfigure the multiplying factor,

FINAL FORMULA

So Graham's intrinsic formula after evaluating all of the above looks like,

EXERCISE TIME

Let's kick this off with an example;
Considering Bata's stock, 
(Ohhh! I loooooooooooooove bata footwear, so extra comfortable!💗)




Right now what you are staring into is a screenshot of Valuations of 'Bata India' stock on moneycontrol.

The first thing to look for calculating the Intrinsic Value is the Earning Per Share (EPS).

In this case, EPS = 25.44, but for calculation, ease lets approximate it to '25'.

Now that you know where to find the EPS, let's move ahead and find out the 'Growth Rate'.





Different people have different opinions on growth rate and hence this variable is subjective and varies person to person. I most of the times prefer to consider this value from screener.

Here, we'll consider the last 3 year's average growth rate as the future projected growth rate. If the company has good future prospects the growth rate in future may be higher than the past.

In our case, g = 6.65%.

The next number hunting is for the 'Bond Yield', i.e variable 'Y'.




Above is the screenshot of '10 Years Yield of AAA Corporate Bonds' in India. I picked this from Investing.com

We get Y = 5.821

Let's fill them in the formula and see what Intrinsic Value we get,

Here, we get the Intrinsic value as 315.15 and the current price (Last traded price) as 1414.25.

So now what?

Here we have a rough understanding at staring at the prices, whether to invest in such this stock or not? shall I wait for a downfall? will the intrinsic value of the stock increase?

But if the particular company has very good prospects, its earnings are going to increase, its EPS will peak, its growth rate will be higher in the future, the intrinsic value also changes, and it will either match or increase the prevailing price in the market.

But preferably it is advised to invest in shares that are either less than or equal to intrinsic value.

CONCLUSION

Benjamin Graham’s intrinsic value formula is only the first baby step towards stock valuation. It can only give a rough idea of the intrinsic value of a stock. But one must not base their decision on this formula alone.

Calculating Intrinsic Value is not the exact science, because we are doing this on the basis of certain assumptions, so the number which we calculate is not an exact number, it may change from person to person, it cannot be done with 100% accuracy.

But it will definitely give you a broad idea and a benchmark to take the right decision.

Don't forget to consider the margin of safety.

In my opinion, this concept is very useful for long term investing.

I hope you apply this formula and take the right decision!

Until next time...

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1 Comments

  1. Thanks for explaining this in such a easy way. Looking forward to the next article in the investing series 🙂

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