This is considered as the fair value of a stock assuming
that an investor has all the information that is available in the market on the
stock in terms of tangible and intangible factors.
The discounted value of cash that can be taken out of
business during its remaining life.
Intrinsic value, commonly used by value investors, will be
used to determine if the market price of the stock is overvalued or undervalued.
If the intrinsic value is higher than
the market price of the stock, the stock is UNDERVALUED and the
investor would purchase it.
If the intrinsic value is lower than
the market price of the stock, the stock is OVERVALUED, the investor
would sell it or take a short position (refer to article on derivatives).
By calculating the intrinsic value an investor determines
the margin of safety. The margin of safety is the percentage difference
between intrinsic value and current stock price. It is assumed that the higher
the margin of safety, the “better/ safer” the investment and the limited
downside risk.
The intrinsic value cannot be used on its own to determine
if a stock is worth buying, however, it provides a good estimate while carrying
out the analysis.
Formulas used in the calculation of intrinsic value are:
This model is commonly used in the calculation of the intrinsic value. It is considered as a multi-stage dividend discount model whereby the growth rate is assumed to change. It is written as;
Value of the Stock = D/ (1+r)1 +D2/(1+r)2+ …….+Dn/(1+r)n +Pn/(1+r)n
D - Expected Dividend in the given year.
r- Required rate of return.
Pn= (Dn+1 )/(r-g)
Limitations of this are that it will not work for companies that do not pay dividends.
For Constant Dividends:
P=Dt / r where:
P - Intrinsic value
Dt- Expected dividend
r- Appropriate discount factor for the investment
This method is useful for analyzing preferred shares where the dividend is fixed.
This is a type of DDM and assumes that the business has a steady growth, most industries in the mature stage.
It is calculated as;
Value of Stock= D/ r-g
D – Expected Dividend Growth Rate
r- Required Rate of Return
g- Growth rate which is calculated as Return on Equity* Retention Ratio.
This will assume that the firm has a constant growth rate to
perpetuity which might not be the case in reality and thus use of the multi
stage dividend discount model.
DCF uses the Free Cash Flow projections and discounts them using the calculated Cost of Capital to get the fair value of the stock.
Value of the Stock = CF1/ (1+d)1 +CF2/ (1+d)2 +……+CFn/(1+d)n
CFn- Cash flows in period.
d- Discount rate.
Limitations of the DCF is that it requires a lot of time in calculating however it will provide a more accurate value as it is hard for the company to manipulate its cash flows.
This is the use of readily available information from the financial statements to calculate the intrinsic value.
Value of the Stock = B0 +∑ (EPS- r) Bn-1/(1+r)n
B0- Current per Share Book Value
Bn-1 – Expected per Share book Value of equity at n.
EPS-Expected EPS
r- Require rate of return on investment.
The use of residual income model is helpful to firms that do
not pay dividends or generate positive free cash flows. The limitation of using
the residual income model is as it relies on the companies statements it will
be vulnerable to bias information and data that is outdated.