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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.
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:
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.
Risk adjustment in cash flows is a blend of art and science, involving two primary methods:
Also Read: Volume Weighted Average Price
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.
When evaluating a company as a going concern, industry practitioners commonly employ three primary valuation methods:
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
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.
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.
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:
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.
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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