“Intrinsic value” is a philosophical concept, wherein the worth of an object or endeavor is derived in and of itself—or, in layman’s terms, independent of other extraneous factors. A company’s stock also is capable of holding intrinsic value, outside of what its perceived market price is, and is often touted as an important aspect to consider by value investors when picking a company to invest in.
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!”) However, in this article, we will look at another way of figuring out the intrinsic value of a stock, which reduces the subjective perception of a stock’s value by analyzing its fundamentals and determining the worth of a stock in and of itself (in other words, how it generates cash).
- Intrinsic value refers to some fundamental, objective value contained in an object, asset, or financial contract. If the market price is below that value it may be a good buy, and if above a good sale.
- When evaluating stocks, there are several methods for arriving at a fair assessment of a share’s intrinsic value.
- Here, we consider several of these models that utilize factors such as dividend streams, discounted cash flows, and residual income to a company.
- Each model relies crucially on good assumptions. If the assumptions used are inaccurate or erroneous, then the values estimated by the model will deviate from the true intrinsic value.
Why Intrinsic Value Matters
Why does intrinsic value matter to an investor? In the listed models above, analysts employ these methods to see if whether or not the intrinsic value of a security is higher or lower than its current market price, allowing them to categorize it as “overvalued” or “undervalued.” Typically, when calculating a stock’s intrinsic value, investors can determine an appropriate margin of safety, where the market price is below the estimated intrinsic value. By leaving a ‘cushion’ between the lower market price and the price you believe it’s worth, you limit the amount of downside that you would incur if the stock ends up being worth less than your estimate.
For instance, suppose in one year you find a company that you believe has strong fundamentals coupled with excellent cash flow opportunities. That year it trades at $10 per share, and after figuring out its DCF, you realize that its intrinsic value is closer to $15 per share: a bargain of $5. Assuming you have a margin of safety of about 35%, you would purchase this stock at the $10 value. If its intrinsic value drops by $3 a year later, you are still saving at least $2 from your initial DCF value and have ample room to sell if the share price drops with it.
ora beginner getting to know the markets, intrinsic value is a vital concept to remember when researching firms and finding bargains that fit within his or her investment objectives. Though not a perfect indicator of the success of a company, applying models that focus on fundamentals provides a sobering perspective on the price of its shares.
The Bottom Line
Every valuation model ever developed by an economist or financial academic is subject to the risk and volatility that exists in the market as well as the sheer irrationality of investors. While calculating intrinsic value may not be a guaranteed way of mitigating all losses to your portfolio, it does provide a clearer indication of a company’s financial health, which is vital when picking stocks you intend on holding for the long-term. Moreover, picking stocks with market prices below their intrinsic value can also help in saving money when building a portfolio.
Although a stock may be climbing in price in one period, if it appears overvalued, it may be best to wait until the market brings it down to below its intrinsic value to realize a bargain. This not only saves you from deeper losses but allows for wiggle room to allocate cash into other, more secure investment vehicles like bonds and T-bills.