What is Intrinsic Value?

8 Mar 2021by Pradeep U

What is Intrinsic Value?

When it comes to investing in stocks, the majority of investors make a grave mistake of investing by looking at the share price than the value associated with it. As a result, they often end up losing their money in the stock market.

We often come across investors who claim that a stock trading at Rs. 50 appears to be a better buy than a stock trading at Rs. 1000. Their argument to support this claim is that they can simply buy more quantity of stock trading at Rs. 50 than the stock trading at Rs. 1000 without looking at the actual value associated with the stock.

There are many banking stocks available in the banking sector for single-digit and double-digit prices such as Dhanlaxmi Bank, South Indian Bank (SIB), and Jammu & Kashmir Bank. On the other hand, the market leader in the segment HDFC Bank is trading at a four-digit price and there is a reason why value investors still consider a good buy.

HDFC Bank's consistent growth in market share, pan-India presence, lowest NPA, asset quality control, significant deposit, and market credit share are some of the factors which make it a value buy.  All these fundamental strengths justify the high stock price of HDFC Bank. However despite being a consistent compounder for last few decades it is equally important to look at the stock's instrinsic value to avoid overpaying for it.

In this article let's take a look at 'What is intrinsic value' and how investors can use intrinsic value as a measure to choose the right stocks for wealth creation.

Before we proceed further let's take a look at why buying an asset without looking at its intrinsic value may end up creating a bubble, especially when everyone else around is also doing the same.

The best example of this is the 'Tulip Mania' during the Dutch Golden Age considered to be one of the most famous market bubbles of all time.

In 1636, speculation raised the value of tulip bulbs to extremes levels in Holland.

As the word about lucrative profits from tulip trading spread quickly, people from different walks of life from cobblers, carpenters, maids, mechanics, farmers, and nobles, started buying and selling tulip bulbs, taking prices sky-high. According to estimates in the year 1633, a single bulb of a rare variety of tulips was worth a whopping 5,500 guilders. By the year 1637, the price doubled, to almost 10,000 guilders, a princely sum that could buy a luxury home in Amsterdam then.

And then one day in February 1637, the market for tulips collapsed as fast as it had risen. The demand for tulips disappeared overnight. With no buyers, sellers who had invested heavily in buying tulip bulbs were left high and dry resulting in a financial disaster for many.

Today the term "tulip mania" is often symbolically used to describe a large economic bubble when the price of the asset varies too much from its intrinsic value. The underlying reason for the collapse of the bubble was the fact that there was no real value associated with tulips which warranted its extra-ordinary price. In simple words, there was no intrinsic value associated with tulips and due to high demand and low supply prices of tulips were touching new highs before the bubble burst.

In Berkshire Hathaway's annual meeting notes for the year 2007, there is an excellent example by Warren Buffett where he describes in with a simple example the significance of intrinsic value.

In the example, Buffett gives the reference of buying a farm which generates a revenue of $70 per acre for the owner. He asks how much would a person wanting to buy the farm, pay per acre for the farm. He says if the yield will get better, prices will increase and it would generate a 7% return, so a payment of $1,000 per acre would be fine. If the same farm is available for a sale for $800, it is worth buying but if the price is $1,200, it is not worth buying.

Now that you have understood 'What is intrinsic value?' let's proceed to the next step

How is the intrinsic value of a stock calculated?

Investors and analysts use different valuation models based on both quantitative and qualitative factors to calculate a stock's intrinsic value. One of the most popular approaches towards calculating the intrinsic value of a stock is the Discounted Cash Flow analysis model.

There are three key steps involved for calculating a stock's intrinsic value such as estimating all of a company's future cash flows, calculating the present value of all those future cash flows, and adding up the present values to calculate a stock's intrinsic values.

Another popular approach used by experts for calculating the intrinsic value of a stock is the Gordon Growth Model (GGM.

In this model, the intrinsic value of a stock is determined on the basis of a future series of dividends that grow at a constant rate. While using this model for calculating the intrinsic value it is assumed that the dividend grows at a continuous rate in eternity and solves for the current value of the endless series of future dividends. As this model is based on the assumption of a continuous growth rate, it is mostly used only calculating the intrinsic value for companies that have stable growth rates in dividends per share.

Calculating the above values does require a thorough understanding of the financial statements of a company and a decent amount of time. In case you do not have the time for the same or lack the necessary skill to study financial statements, you can always rely on experts like Research & Ranking to make investing a hassle-free experience.

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Key takeaways

Intrinsic value is a key metric that helps an investor to identify the real worth of a stock. Legendary investors like Warren Buffet and Benjamin Graham have created immense fortunes through value investing based on the intrinsic valuation method.

No matter how good a stock is, it makes absolutely no sense to buy it at the wrong price. The basic objective of calculating a stock's intrinsic value is to purchase it when it is trading at a lesser price than its real worth.



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