If you’re new to value investing, you’ll hear about “intrinsic value” a lot, because we only want to buy a stock if we think its price is lower than its intrinsic value (eg we want to buy it at a discount).
But what does the term “intrinsic value” mean from an investing perspective? And how do we calculate it?
Intrinsic value is a term used in finance to describe the inherent or true value of an asset, such as a company’s stock or a bond. It is a key concept in fundamental analysis, which is a method of evaluating securities by analyzing their underlying financial and economic characteristics. The intrinsic value of an asset is considered to be distinct from its market price, which is determined by supply and demand forces in the market.
One way to think about intrinsic value is as the present value of the future cash flows that an asset is expected to generate. For a company’s stock, this means considering the company’s future profits, dividends, and any other sources of value that the company may generate. The intrinsic value of a bond, on the other hand, is typically based on the present value of the bond’s future interest payments and principal repayment.
Determining the intrinsic value of an asset is an important task for investors, as it can help them make informed decisions about whether to buy or sell the asset. If an asset is trading at a price that is significantly lower than its intrinsic value, it may be considered undervalued and potentially a good buying opportunity. On the other hand, if an asset is trading at a price that is significantly higher than its intrinsic value, it may be considered overvalued and potentially a good selling opportunity.
There are several methods that can be used to estimate the intrinsic value of an asset, each with its own strengths and limitations. Some of the most common methods include:
- Discounted Cash Flow (DCF) Analysis: This method involves estimating the future cash flows that an asset is expected to generate and then discounting those cash flows back to their present value using a discount rate. The discount rate is a measure of the time value of money, which reflects the idea that a dollar received in the future is worth less than a dollar received today. The intrinsic value of the asset is then calculated as the sum of all the discounted cash flows.
- Price-to-Earnings (P/E) Ratio: This method involves dividing a company’s stock price by its earnings per share (EPS). The resulting ratio, known as the P/E ratio, is a measure of the company’s valuation relative to its earnings. A lower P/E ratio may indicate that a stock is undervalued, while a higher P/E ratio may indicate that it is overvalued.
- Dividend Discount Model (DDM): This method involves estimating the future dividends that a company’s stock is expected to pay and then discounting those dividends back to their present value using a discount rate. The intrinsic value of the stock is then calculated as the sum of all the discounted dividends.
- Comparable Companies Analysis: This method involves comparing the financial and operating metrics of a company to those of similar companies in the same industry. By examining metrics such as P/E ratios, price-to-book ratios, and return on equity, investors can gain insight into the relative valuation of a company.
It is important to note that determining the intrinsic value of an asset is not an exact science, and different methods may yield different results. Additionally, the intrinsic value of an asset can change over time as the underlying economic and financial factors that drive it change. As a result, it is important for investors to regularly reassess the intrinsic value of their assets and make adjustments to their portfolios as needed.
In conclusion, intrinsic value is a concept that is central to fundamental analysis, and it refers to the inherent or true value of an asset. Determining the intrinsic value of an asset can help investors make informed decisions about whether to buy or sell the asset, and there are several methods that can be used to calculate it.
Because determining intrinsic value is such a dark art, in the QAV system we take a “heat map” approach to determining whether or not a stock is undervalued. We look at several intrinsic value calculations and combine them with a bunch of other metrics, giving each a score, and then buying the stocks with the highest total score (aka the QAV Score).