Intrinsic value

Intrinsic value – The difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the counterparty is (or will be) required to pay for those shares. For example, a share option with an exercise price of CU15, on a share with a fair value of CU20, has an intrinsic value of CU5.

In finance, intrinsic value refers to the value of a company, stock, currency or product determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the discounted future income generated by the asset to obtain the present value. It is worthy to note that this term may have different meanings for different assets.

Benjamin Graham and Warren Buffet are widely considered the forefathers of value investing, which is based on the intrinsic valuation method. Graham’s book, The Intelligent Investor, laid the groundwork for Warren Buffett and the entire school of thought on the topic.

The term intrinsic means the essential nature of a something. Synonyms include innate, inherent, native, natural, deep-rooted, etc.

Some buyers may simply have a “gut feeling” about the price of a stock, taking into deep consideration its corporate fundamentals. Others may base their purchase on the hype behind the stock (“everyone is talking positively about it; it must be good!”).

Investors are interested in cash available to stockholders. The internal factors above determine how much cash a company can expect to generate. So the methods we will learn that compute intrinsic value are based on cash generated and expectations for future growth.

Why Calculate Intrinsic Values?

Analysts and investors calculate intrinsic values for an important reason, they identify underpriced stocks. If an investor calculates an intrinsic value of $300 for a stock, and it is trading on the market for $250, it will be perceived as a bargain price and a good investment.

The Dividend Discount Method

The dividend discount method (DDM) is a quick and easy way to evaluate intrinsic value. It is especially useful for large, stable companies. The commonly used formula for the Gordon Growth version of the DDM is focused on dividends, which are cash paid to stockholders and their future growth. It is:

Intrinsic Price of Stock = DPS1 / (r – g)

where:

DPS1 = Expected dividends one year from the present

r = The discount rate or required rate of return on the investment

g = The annual growth rate of dividends in perpetuity

For instance, Mountain Energy Company is an established public utility with a stable customer base. It expects to pay a $15 dividend per share this year, which has had a stable 3% growth over the years. We will use 3% for g in the formula. The required rate of return for this type of investment is 8%, which is r in the formula. The intrinsic value of Mountain Energy Company’s shares is:

$15 / (.08 – .03) = $300

The Discounted Cash Flow Method

The most widely used method for getting at intrinsic value is the discounted cash flow (DCF) method. It uses free cash flows rather than dividends to come up with a value. This method is also very flexible in that it allows for cash flow estimates to vary from year to year and works for any size company!

Let’s go through a simple example step-by-step. Cy Cycles carries a full line of road and mountain bikes. Cy and his partners have two very successful retail locations and plan an aggressive expansion over the next five years. They want to issue 3,000 shares of stock to investors and family members who will put down their money and make the growth possible. Cy and his partners are interested in estimating the intrinsic value of these shares. Beth is the partner who is the wizard of finance for the business! She and Cy are going to go through the steps to find out.

  1. Project free cash flow for the forecast years. Cy expects to have $10,000 in free cash flow for the current year. He expects that cash flows will grow by 20% each year for next five years.
  2. Come up with a discount rate. The number to focus on is assumed cost of equity. Beth tells Cy she will use 8%.
  3. Discount the projected free cash flows to present value. Beth has worked up a table that shows the estimated cash flows discounted for the first five years. Here it is:
Year Free cash flow (CU) Discount calculation Present value free cash flows (CU)

1

10,000

10,000 / 1.08

9,259

2

12,000

12,000 / 1.08^2

10,288

3

14,400

14,400 / 1.08^3

11,431

4

17,280

17,280 / 1.08^4

12,701

5

20,736

20,736 / 1.08^5

14,113

After five years there is still a business that has value, the terminal value – Cy Cycles has done some investigation into past and similar transactions in the neighborhood and concludes that the terminal value is at best estimated as follows (as above):

r = The discount rate or required rate of return on the investment – 10%

g = The annual growth rate of free cash flows in perpetuity – 5%

the discount factor for the terminal value is then 1 / (0.1 – 0.05) = 20 times the free cash flow in year 5, i.e. 20,736 * 20 = 414,720, discounted 414,720 / 1.08^5 = 282,251. The total value is then the sum of all the present values or 340,043 or 113.34 per share (3,000 shares to be issued).

Intrinsic value

Intrinsic value

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