What Is Intrinsic Value?

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What Is An Intrinsic Value

The intrinsic value of a share or stock represents its expected worth, which is determined by fundamental analysis and takes into account both tangible and intangible factors. Often referred to as the genuine value, it may differ from the current market price. In essence, it signifies the price a rational investor would be willing to pay for an investment, considering its associated level of risk.

Formula For Intrinsic Value

The basic formula for determining the intrinsic value of a business or any investment asset typically involves calculating the present value of all future cash flows, which is discounted using an appropriate discount rate. This approach closely resembles the net present value formula, with the standard symbols as follows:

  • NPV = Net Present Value 
  • CFi = Net cash flow for the ith period ( for the first cash flow, I = 0)
  • r = Interest Rate
  • n = Number of Periods 

Analysing Intrinsic Value Of Stock Options

To determine intrinsic value, value investors employ fundamental analysis, which involves assessing both qualitative and quantitative factors.

Qualitative factors encompass aspects like the business model, governance, and market conditions. Quantitative factors involve examining financial statements. Comparing the resulting intrinsic value with the market value helps assess whether the asset is overvalued or undervalued.

Adjusting for Risk in Intrinsic Value Options Assessment

Risk adjustment in cash flows is a blend of art and science, involving two primary methods:

1. Discount Rate:

  • Analysts typically utilise a company’s weighted average cost of capital.
  • This figure comprises the risk-free rate (derived from government bond yields) and an equity risk premium influenced by stock volatility.
  • The concept is grounded in the belief that more volatile stocks carry higher risk, requiring a higher discount rate, which lowers the expected future cash flow value.

Also Read: Volume Weighted Average Price

2. Certainty Factor:

  • This method assigns a certainty factor or probability to each cash flow or multiplies it with the entire net present value (NPV).
  • Cash flows are risk-adjusted using the risk-free rate as the discount rate.
  • For example, government bond cash flows are assigned a 100% certainty, using a 7% discount rate.
  • Cash flows from high-growth companies with a 50% probability factor use the same discount rate due to the embedded risk.

Challenges in Intrinsic Value Assessment

Intrinsic value computation is inherently subjective, relying on various assumptions to project cash flows, making the final net present value sensitive to changes in these assumptions. Factors like beta and market risk premium can also vary when calculating the weighted average cost of capital. Moreover, the subjective nature of probability factors adds complexity.

Furthermore, the uncertainty of the future poses a challenge. Different investors may arrive at varying values for the same asset due to their distinct perspectives on the future, making it impossible to pinpoint a single accurate number.

Valuation Methods

When evaluating a company as a going concern, industry practitioners commonly employ three primary valuation methods:

1. Comparable Company Analysis (Trading Multiples or Peer Group Analysis):

  • This method, also known as trading multiples, peer group analysis, equity comps, or public market multiples, relies on relative valuation.
  • Analysts compare the company or asset under evaluation to similar businesses by examining trading multiples like P/E, EV/EBITDA, and other ratios.
  • The method derives a value for the business by observing what other comparable companies are worth.

For example, if Company A has a P/E ratio of 10 and Company B earns Rs. 2 per share, the value of each share of Company B would be Rs. 20 (assuming both companies are entirely comparable).

Also Read: PE in the Share Market

2. Precedent Transactions:

  • This method, akin to relative valuation, involves comparing the company under assessment to other businesses recently sold or acquired within the same industry.
  • These past transactions serve as a benchmark to determine the value of the company.

3. Discounted Cash Flow (DCF) Analysis:

  • The DCF method, also known as the Discounted Cash Flow method, is the most widely used approach for determining intrinsic value.
  • Analysts forecast the future cash flows of the business and discount them to their present value using the firm’s Weighted Average Cost of Capital (WACC).

 

Pros And Cons of Intrinsic Value Options

  • Pros

1. Intrinsic value is a valuable tool for assessing the worth of assets, investments, or companies.

2. It aids in quantifying the profit embedded in options contracts.

  • Cons

1. The calculation of a company’s intrinsic value can be subjective as it involves estimating risks and future cash flows.

2. In options, intrinsic value doesn’t account for the premium paid and the element of time value, rendering it incomplete for comprehensive evaluation.

Exploring DCF Method With An Example

Let’s explore the DCF method through an example to illustrate how fair value is calculated:

Assuming you are evaluating a company with the following cash flows:

  • Cash flow for the first five years starting in 2019: Rs 100
  • Discount rate: 10%
  • Terminal growth rate: 5%

The present estimation of the cash flow generated in 2019 is calculated as follows:

Present Value = CF / (1 + r)^n

Present Value = 100 / (1 + 10%)^1

Present Value = Rs 91

The terminal value is determined using the perpetual growth formula:

Terminal Value = {CF * (1 + growth rate)} / (discount rate – growth rate)

Terminal Value = {100 * (1 + 5%)} / (10% – 5%)

Terminal Value = Rs 2100

The present worth of the terminal value is calculated in a similar manner as shown above. 

Conclusion

In summary, intrinsic value plays a pivotal role in the evaluation of stocks for investment. Now that you understand what is intrinsic value in options, there exist various approaches to determine this fair value, and it is essential for an investor to select the most suitable method considering the specific industry and company attributes they are analysing.

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