Three Ways to Calculate Intrinsic Value

Imagine this: You’re standing at the crossroads of financial decisions. To your left, a company’s stock price is riding high, fueled by hype and speculation. To your right, another stock appears undervalued, overlooked by the market. How do you know which is the right choice? The answer lies in calculating the intrinsic value.

But what is intrinsic value, and how can you, as an investor, calculate it effectively? Intrinsic value is the actual worth of an asset, independent of market fluctuations. Investors use various methods to estimate this value to make informed decisions about buying, holding, or selling an asset. This concept serves as a guiding light, especially during volatile times when market prices can deviate significantly from an asset’s true worth.

In this article, we'll dive deep into the three key methods for calculating intrinsic value. These approaches offer different perspectives and insights, helping you gauge whether an asset is overvalued or undervalued in relation to its true worth. By the end, you'll be armed with actionable knowledge to confidently navigate the stock market.

1. Discounted Cash Flow (DCF) Analysis: The Core Method for Estimating Intrinsic Value

The Discounted Cash Flow (DCF) method is one of the most widely used techniques for determining intrinsic value. At its core, DCF relies on the premise that a company’s value is the sum of all its future cash flows, adjusted for the time value of money. In simpler terms, it’s about calculating how much money a company will generate in the future and translating that into today’s dollars.

Why Use DCF?

Imagine you’re considering purchasing a rental property. You'd want to know how much rent the property could generate over the next few years and whether that would justify the price. DCF works in a similar way but applies to businesses. You project a company’s future earnings (free cash flow), then discount those future cash flows back to their present value using a discount rate (usually the company’s weighted average cost of capital or WACC).

Steps to Perform a DCF Analysis:

1. Project Future Cash Flows: Estimate the company’s free cash flow (FCF) over a certain period (e.g., 5-10 years).
2. Calculate the Terminal Value: This represents the value of the business beyond the forecasted period. It’s usually calculated using a perpetuity formula.
3. Discount Future Cash Flows: Using a discount rate (often the WACC), discount the projected cash flows and terminal value back to their present value.
4. Sum the Present Values: Add the discounted cash flows and terminal value to get the company’s intrinsic value.

Example:

Let’s assume you’re evaluating a tech company with projected free cash flows of $100 million over the next five years and a terminal value of $500 million. If the discount rate is 10%, you’d discount those cash flows and terminal value back to their present value. Summing them would give you the intrinsic value.

Pros and Cons of DCF:

• Pros:
  • Highly detailed and tailored to the specific company.
  • Takes into account future earnings potential.
• Cons:
  • Sensitive to assumptions (a small change in cash flow projections or the discount rate can drastically affect the outcome).
  • Time-consuming and requires significant data.

2. Price-to-Earnings (P/E) Ratio: A Quick and Popular Valuation Method

For a faster, more straightforward approach, many investors turn to the Price-to-Earnings (P/E) ratio. This method is especially useful when you need a quick gauge of a company’s valuation relative to its earnings.

How the P/E Ratio Works:

The P/E ratio is calculated by dividing a company’s current stock price by its earnings per share (EPS). The resulting number tells you how much investors are willing to pay for each dollar of earnings. A high P/E ratio might suggest that investors expect high growth in the future, while a low P/E could signal that the stock is undervalued or that growth prospects are bleak.

Example:

Imagine a company’s stock is trading at $50, and its earnings per share are $5. The P/E ratio would be 10. This means investors are willing to pay $10 for every $1 of the company’s earnings.

P/E Ratio in Context:

While the P/E ratio is a useful shorthand, it’s best used in conjunction with other methods. For instance, comparing a company’s P/E ratio to the average P/E of its industry can provide context. If the industry average is 20 and the company’s P/E is 10, it might suggest the stock is undervalued. However, be cautious: a low P/E might also indicate that the market has little confidence in the company’s future prospects.

Pros and Cons of the P/E Ratio:

• Pros:
  • Easy and quick to calculate.
  • Good for comparing companies within the same industry.
• Cons:
  • Doesn’t account for future growth or risk.
  • Can be misleading if a company’s earnings are temporarily inflated or depressed.

3. Net Asset Value (NAV): Focusing on the Company’s Assets

Another way to calculate intrinsic value is by focusing on a company’s assets. This approach, known as Net Asset Value (NAV), is particularly useful for industries like real estate or investment management, where the value of a company’s assets is more tangible.

How NAV Works:

NAV is essentially the total value of a company’s assets minus its liabilities. It’s calculated as:

$\text{NAV}=\frac{\text{Total Assets}-\text{Total Liabilities}}{\text{Number of Outstanding Shares}}$NAV=Number of Outstanding SharesTotal Assets−Total Liabilities​

This method provides a snapshot of what the company’s assets would be worth if liquidated today. NAV is most useful for industries where tangible assets (like property, machinery, or inventory) make up a significant portion of the company's value.

Example:

Let’s say a real estate company owns $500 million in properties and has $200 million in liabilities. If the company has 10 million outstanding shares, the NAV per share would be:

$\text{NAV per share}=\frac{\$500M-\$200M}{10M}=\$30$NAV per share=10M$500M−$200M​=$30

If the company’s stock is trading at $25, it might be undervalued based on its NAV.

Pros and Cons of NAV:

• Pros:
  • Useful for asset-heavy industries.
  • Provides a clear picture of the company’s tangible worth.
• Cons:
  • Doesn’t account for future growth or earnings potential.
  • Can be misleading if assets are difficult to value or if the company is in an industry with significant intangible assets (like tech or pharmaceuticals).

Conclusion: Which Method Should You Use?

Ultimately, the best approach depends on the type of company you’re evaluating and the context of your analysis. For companies with strong cash flows and growth potential, DCF is often the most reliable. If you’re looking for a quick snapshot of valuation, the P/E ratio can be useful. Meanwhile, for companies with significant tangible assets, NAV offers a more grounded perspective.

That said, no single method is perfect. Investors often combine multiple approaches to get a well-rounded view of a company’s intrinsic value. Understanding how to apply these techniques can give you a significant edge in the market, allowing you to spot opportunities where others see uncertainty.

By applying these intrinsic value calculations, you’ll be better equipped to make investment decisions that are based on a company’s true worth—not just the whims of the market.