Intrinsic Value: What is it and how to calculate?

Posted byKIRAN Uat June 30. 2012

Dear Donald & Team Valuepickr,

First of heartly congratulation & thanks to Donald & Team Valuepickr to start this wonderful initiative to Ideas,Impliment & Learn.

I want to know & clear doubt about the question that are,

  1. What is Intrinsic Value of Stock ?

  2. How it is calculated by different methods ??

  3. Step by step procedure of Calculating it with recent Market example ??

I hope to get new light on Intrinsic Value & Team Valuepickr Experience of it.

Posted byAdministratorat Monday 16:20

Hi Kiran,

Theoretically this is a very important concept in your toolkit. The concept is useful and very fundamental to the way we think about the value of a stock.

PAT Dorsey, in his5 Rules for Successful Investingbook has given a simple explanation of the concept of Intrinsic Value and gives step-by-step instructions for calculation.Intrinsic Value,Discounted Cash Flowsarticles at ValuePickr attempt to capture its essence in brief.

That was the easy part:))

Applying it practically is very difficult…simply because very few businesses enjoy predictability in cash flows. And to be able to project cash flows 10 years into the future is even more difficult, if not impossible! The assumptions on Growth and the discounting if tweaked even slightly…lead to very different results …over 10 years!

It has practical utility in M&A kind of situations. It is pretty useful for the owners/buyers of a business…because they are privy to all the business information at their disposal…and can develop a much better feel for the predictability of the business and the cash flows.

But for lay investors like us, it has use as a guideline mostly. Its practical use is limited to giving us the valuation range and enable us to check out a few scenarios.

ValuePickr’s experience has been that …when a stock is cheap, it screams cheap…on most valuation parameters. We haven’t needed DCF or other complicated valuation spreadsheets, to establish if a stock is cheap:))

Here’s some Guruspeakon the practical use of DCF!

Previously KIRAN U wrote:

I want to know & clear doubt about the question that are,

  1. What is Intrinsic Value of Stock ?

  2. How it is calculated by different methods ??

1 Like

Kiran, I would suggest that you read Warren’s remarks about Intrinsic value. It is not easy to value it. So it has to be a screaming buy! We do not really need to know the exact weight of any person to know that he is Fat. I somehow have never ever used DCF. In fact i never ever even rely on ratios like PE, BV, EPS etc. I do not find them useful tools to know whether that stock is a screaming buy.

JM

Janak

Would you like to share the tools that you use to identify if a stock is screaming buy.

As mentioned in the above post as well “…when a stock is cheap, it screams cheap…”

Would appreciate if seniors can throw some more light on this aspect.

Thanks,

Atul

Yup, so we know DCF etc are not used, but then what is used??

Intrinsic value is a difficult number to calculate, because it involves so many assumption, which might or might not be valid in future. DCF calculation requires the user to predict future growth rate of the company, which we know for sure that no one can predict.

I find “the concept of margin of safety” a better proxy to intrinsic value. In margin of safety, you try to buy stocks which have lower downside (lower probability and lower downside) and significantly high upside potential and probability.

I know no quantitative way to find the probability and potential. The qualitative way of finding such stocks are looking for parameters like

1> Cheap valuation parameters (like pe, peg ratio, divident yield, cash yield, roe, roce, growth)

2> Good moat

3> Excellent management track record

4> New change in business environment, which is going to effect the company in a big way

1 Like

While calculating intrinsic value, Ifollow DCF valuation approach because of its conceptual simplicity& strong focus on cashflows. However the problem lies in identifying reinvestment rate.Can any senior member give an idea how toassess reinvestment rate? In certain sectors whichareheavy/moderately capital intensive, such figure canturn the valuation upside down. Can anybody throw light on this?

Hi Kiran,

Intrinsic value is an abstract concept, but some people have used methods to calculate or estimate it. Let me try to answer as far as I can

  1. What is Intrinsic Value of Stock ?

It is the true value of a stock based on the current business situation and future potential. Generally it can be calculated by discounting future cash flows and bring them to present value.

  1. How it is calculated by different methods ??

One method is Discounted Cash Flow methods. However, there are several other methods or variants. Some people calculate the tangible book value as the least value that the company can get on liquidation, and to this tang. BV they add future earnings or cash flows to arrive at an estimate. These are just broad ideas, and each analyst or expert would use their method.

All said and done DCF is the most common though it has its pitfalls.

Relative method uses PE, PB, etc. and the value at which the company commands a fair PE could be considered as IV, and when stock prices dips below IV it presents a buying opportunity.

  1. Step by step procedure of Calculating it with recent Market example ??

I hope to get new light on Intrinsic Value & Team Valuepickr Experience of it.

There is no particular method or formula that is universally accepted. For instance if you want to measure the value of an Antique Gramaphone there can be several value estimates by different people and its quite complex. Sames holds true to an extent for real estate or property.

One method values a stock or a company like a bond, where the dividend and BV are used instead of interest and price of a bond. You take future year’s expected dividends for say 10 years, and in 10th years you calculate the forecast BV (which is current BV X BV growth rate). Here BV growth rate will be based on BV growth in the last 10 years. However, you need to study the financial trends and make sure the company has consistent or reasonably consistent performance in the past. (this is more important than the method itslef). (The dividends and Book value used above are ‘per share’ figures)

Second method is estimating Owners Earnings, which is also advocated by value investors including gurus like Warren Buffett (though I’m not sure if he personally uses the same).Owner’s Earnings are different from accounting earnings. Owners earnings = Cash Flow from Operations - Capex or purchase of business-related assets/equipment. This is also known as Free Cash Flow to Equity Holder in financial circles. Take the estimated OE for 10 years, then assume a growth rate for the first phase (say 3-5 years) and another slower growth rate for second phase, and calculate terminal value. Now discount all these cash flows to PV to arrive at a value, which is your Intrinsic Value. NOw divide this IV by no. of shares to get the Intrinsic Value per share.

I’m not an expert or authority on this…so take my methods also with a pinch of salt. These are just indicators, so use other factors before making a decision.

Hope this is useful for you! Do share your comments or thoughts on this.

Hi Sridhar,
Please share with an example if possible.

I have seen many people trying to do dcf using 10 year high growth at 15% and then terminal value with 2% growth forever. It doesn’t make any sense to me. I believe some businesses can grow over decades while others die in few years. Please share what you guys think about DCF analysis.

Isn’t it being precisely wrong than being roughly right?