Intrinsic value is the true worth of a company based on its fundamentals, independent of its current market price. Learning to calculate intrinsic value helps you identify undervalued stocks and make better investment decisions. This guide covers the most practical methods for valuing stocks.
What is Intrinsic Value?
Intrinsic value represents what a stock is actually worth based on the company's ability to generate cash flows for shareholders. When the market price is below intrinsic value, the stock may be undervalued. When market price exceeds intrinsic value, it may be overvalued.
Key concept: Intrinsic value is not a precise number but a range. Different valuation methods will produce different results. The goal is to determine whether current price offers sufficient margin of safety relative to your estimate of fair value.
Method 1: Discounted Cash Flow (DCF)
DCF is the gold standard for intrinsic value calculation. It values a company based on the present value of its future cash flows.
DCF Formula
Intrinsic Value = Sum of discounted future cash flows + Terminal value
Step-by-Step DCF
- Project free cash flows: Estimate FCF for 5-10 years
- Determine discount rate: Typically 8-12% (your required return)
- Calculate terminal value: Value beyond projection period
- Discount all values: Bring future values to present
- Sum the values: Add discounted FCF + terminal value
- Divide by shares: Get per-share intrinsic value
Simplified DCF Example
Company ABC current data:
- Free Cash Flow: $100 million
- Expected growth: 10% for 5 years, then 3%
- Discount rate: 10%
- Shares outstanding: 50 million
Year 1-5 FCF: $110M, $121M, $133M, $146M, $161M
Terminal Value (at year 5): $161M x 1.03 / (0.10 - 0.03) = $2,369M
Discounted values summed: approximately $1,900M
Intrinsic value per share: $1,900M / 50M = $38
Method 2: Earnings Multiple Approach
A simpler method using P/E ratios to estimate fair value:
Formula
Intrinsic Value = EPS x Fair P/E Multiple
Determining Fair P/E
- Compare to historical average P/E for the stock
- Compare to industry peer average
- Adjust for growth rate differences
- Consider current interest rate environment
P/E Multiple Example
Company XYZ:
- Current EPS: $5.00
- Historical average P/E: 18x
- Industry average P/E: 16x
- Expected growth: 12% (above industry 8%)
Fair P/E estimate: 17x (between historical and industry, premium for growth)
Intrinsic value: $5.00 x 17 = $85 per share
Method 3: Graham Number
Benjamin Graham's formula for conservative intrinsic value:
Formula
Graham Number = Square Root of (22.5 x EPS x Book Value Per Share)
Application
- Based on P/E of 15 and P/B of 1.5 as reasonable maximums
- Very conservative approach
- Best for stable, mature companies
- Provides clear margin of safety
Method 4: Dividend Discount Model
For dividend-paying stocks, value based on future dividends:
Gordon Growth Model
Intrinsic Value = D1 / (r - g)
- D1 = Next year's expected dividend
- r = Required rate of return
- g = Dividend growth rate
DDM Example
Dividend stock analysis:
- Current dividend: $2.00 per share
- Expected growth: 5% annually
- Required return: 10%
D1 = $2.00 x 1.05 = $2.10
Intrinsic Value = $2.10 / (0.10 - 0.05) = $42 per share
Key Inputs for Valuation
Growth Rate Estimation
- Historical revenue and earnings growth
- Industry growth projections
- Company guidance and analyst estimates
- Sustainable growth = ROE x Retention Ratio
Discount Rate Selection
- Higher for riskier companies
- Typically 8-15% range
- WACC (Weighted Average Cost of Capital) for formal analysis
- Your personal required return
Margin of Safety
Never buy at your calculated intrinsic value. Require a margin of safety:
- 20-30% margin: For stable, predictable businesses
- 30-50% margin: For more volatile or uncertain companies
- Purpose: Protects against estimation errors
Valuation Limitations
Intrinsic value calculations are only as good as your inputs. Small changes in growth assumptions or discount rates dramatically change the result. Use multiple methods, be conservative with assumptions, and always require a margin of safety.
Practical Valuation Process
- Calculate intrinsic value using 2-3 different methods
- Compare results to current market price
- If all methods suggest undervaluation, investigate further
- Apply appropriate margin of safety
- Consider qualitative factors (management, moat, industry trends)
- Make buy/sell decision based on total analysis
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Summary
Intrinsic value calculation is the foundation of value investing. Master DCF analysis for detailed valuation, use P/E multiples for quick estimates, and apply the Graham Number for conservative targets. Always use multiple methods and require a margin of safety. Remember that valuation is an art as much as a science - the goal is to identify stocks trading significantly below your estimate of fair value, not to calculate precise numbers.
Continue your fundamental analysis education: fundamental analysis guide and what is intrinsic value.