Intrinsic Valuation: What, why, 3 Easy Methods, and Formula
Updated: Oct 14, 2022
Intrinsic Valuation is an ancient method used to value companies. It utilizes fundamental analysis and analyzes the earnings and growth of companies, as well as their risk.
The term intrinsic valuation refers to any method of calculating a company's value without reference to market prices. Investment managers often use this approach when they are trying to determine if a stock is undervalued or overvalued.
The opposite approach is called relative valuation, which uses market data to determine if a stock is undervalued or overvalued relative to its peers.
It is a method of stock valuation that attempts to quantify the value of a firm based on its assets, earnings, dividends, and working capital.
Intrinsic valuation estimates the value of a company by projecting cash flows into the future and discounting them to a present value. Although most often used in conjunction with an earnings projection, it can be applied to all assets, including businesses, bonds, and real estate. The technique is simple in concept: if a company has a stream of positive cash flows over time and the cost of debt is greater than the cost of equity, then each cash flow can be discounted back at the appropriate rate for those, theoretically retrieving its value.
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Why Understanding Intrinsic Valuation is so Important?
Intrinsic valuation is the process of estimating the value of an asset. It is different from relative valuation, which compares the performance of one security with another. It can be used to determine a company’s share price or the value of a stock option.
Intrinsic valuation is important for two reasons:
1. It allows investors to get a clearer idea of how much they can expect to earn from their investment.
2. It helps companies better understand their worth and avoid being sold at a low price by an opportunistic buyer.
3. Intrinsic valuation considers both tangible and intangible assets. Tangible assets are things like cash and inventory; intangible assets are things like patents, trademarks, and brands.
Intrinsic valuation is particularly useful when it comes to valuing tech companies like Facebook, Google, or Uber, which have no physical assets but still have significant market value due to their intellectual property (IP).
What to Include in Intrinsic Valuation?
There are four main components of intrinsic valuations:
The value of the business's assets (both tangible and intangible).
Any debt or other financial obligations that need to be repaid by the business.
The future earnings potential of the business.
Discount rate: This refers to the rate of return required by investors on their investment capital.
What to not Include in Intrinsic Valuation?
When valuing a company, there are a few things that should be excluded from intrinsic valuation:
Taxes - Taxes can have a significant impact on intrinsic valuations since they're calculated as after-tax profits, not pre-tax profits. Therefore, taxes should be excluded from any intrinsic valuation calculations.
Capital expenditure- The capital expenditure incurred in the past cannot be included in intrinsic valuation. It should be treated as an expense that has already been incurred on the company’s balance sheet and does not represent the present value of future cash flows from operations.
Debt- A company’s debt should be treated as a liability and not as an asset when calculating its intrinsic value. Considerable care needs to be taken while dealing with debt when it is convertible into equity or when there is an option to buy back shares at a price lower than the current market price or when there is a sinking fund requirement after which the bond would automatically convert into equity, etc.
What are the Methods to Calculate Intrinsic Valuation?
To calculate intrinsic valuation, you need to know what your company is worth based on its present state, as opposed to its potential future growth trajectory. Here are some common intrinsic valuation methods:
Discounted Cash Flow Analysis
DCF analysis is a technique used to determine a company's fair value by projecting future cash flows (e.g., profit) and discounting them back to present value using a required rate of return (discount rate). It is usually performed every quarter for public companies and annually for private companies. This method assumes that all future cash flows have no risk associated with them, which is rarely true in practice. Nevertheless, DCF analysis remains an effective tool.
To understand more about Discounted Cash Flow Analysis please read our blog
Discounted Cash Flow Valuation: What, How, and Methodology in 4 Easy Steps
Dividend Discount Method
What is a Dividend?
A dividend is a payment made by a company to its shareholders, usually on a quarterly or annual basis. The payment is usually based on the company's earnings and can be used to help investors gauge how well the business is doing.
The amount of a dividend is usually decided by the board of directors based on how much money the company has available after paying off debts and expenses. Dividends can be issued in the form of cash payments, shares, or other securities.
The amount of a dividend can vary widely from company to company and even within the same company over time. Some companies pay out all their earnings as dividends while others retain most of their earnings to expand their operations.
For example- if you own one share and the company pays out $1 per share in dividends, your total payout would be $1. If you own 500 shares and they pay out $1 per share in dividends, your total payout would be $500 (or $500 x 0.01 = $5).
What is Dividend Discount Method?
The Discount Dividend Model is a financial model used to determine the fair value of a stock. It assumes that a company's value can be determined by calculating the present value of its future dividends. It uses dividends as an estimate for future equity returns. This gives us a discount rate based on our required return and the dividend yield on the stock.
The Dividend Discount Method is used for two purposes:
1) To determine the fair value of a share of common stock in a publicly-traded company (if you want to buy or sell shares).
2) To determine the fair value of a privately held company. For example, if you wanted to buy a privately held company, you could use this method to determine what its value would be if it were public and therefore had to set its price for its stock.
The three types of DDM are:
No growth model - The No growth model applies when the company does not anticipate any growth in its earnings or dividends.
Once a firm is mature (and typically large), it will grow little or not at all. Return on equity and dividends per share will stay constant.
Constant growth model - The constant growth model assumes that a company's dividend will grow at an annual rate forever. This is what you expect if you're investing in a company with a long history of consistent growth.
Variable growth model - The variable growth model, on the other hand, recognizes that not all cash flows are certain. Some cash flows can be very volatile and unpredictable. In this model, different growth rates are considered for each year.
Basic Formula or How to Calculate DDM?
Where,
P = Stock price or Value of stock
D = Dividend
r = Required return on common stock (cost of equity) or discount rate
n= number of years
g= Growth rate
Residual Income Method
The residual income valuation method is a common way to find the value of an income-producing asset.
It is defined as the amount of money that remains after deducting all the costs involved in producing a product or service. The approach is most effective for assets (or liabilities) that produce regular inflows of income that are relatively easy to predict, as opposed to assets (or liabilities) that are irregular and infrequent.
It calculates the amount of money that a company can earn after the cost of capital. The formula for residual income is:
Residual Income = Net Income – Equity Charge
Equity Charge = Equity Capital x cost of Equity
It (also called Residual Earnings) represents the amount of earnings that a company has left over after accounting for interest expenses and tax liability. This amount can be calculated by subtracting a firm's Cost of Goods Sold from its Gross Revenue. Residual Income allows investors to see how much money a company earns after all expenses, debt payments, and taxes have been paid.
The residual income valuation model is generally used in conjunction with other valuation methods to provide more accurate valuations.
Advantages of Intrinsic Valuation
The main advantages of intrinsic valuation are as follows:
1. It gives an investor an idea of how much money they could make if they sold their shares at that moment in time. This helps investors determine whether they are buying stocks at fair prices or whether they are paying too much for them.
2. It can be used when one of the important factors such as assets or revenues is unstable.
3. It helps in finding out the intrinsic value of a stock by considering its long-term growth prospects, profitability, etc.
4. Intrinsic value is based on the future earning potential of an asset and its ability to generate cash flows. This makes it easy to determine the intrinsic value of an asset even when there is no liquid market for that asset.
5. Intrinsic value can be calculated for any type of asset, whether it’s tangible or intangible.
6. They are more precise and accurate.
Disadvantages of Intrinsic Valuation
An intrinsic valuation is a useful tool for determining the value of a company or asset. However, there are some disadvantages to this technique.
1. The valuation of a company or asset is subjective and based on assumptions about future earnings, growth rates, and other factors. This means that two analysts can come up with different valuations for the same company if they use different assumptions in their calculations.
2. It is difficult to determine the intrinsic value of an asset because there are no benchmarks to compare against - unlike when you price publicly traded equities on a stock exchange where you can compare prices with those of similar companies and adjust where necessary. This means that intrinsic value estimates can vary widely among analysts who use different methods, leading to confusion among investors who are trying to make investment decisions based on these estimates.
3. It requires a lot of time and effort.
4. You need to be able to estimate growth rates and discount rates. These are not easy to estimate.
5. It does not consider other factors that may influence the value of an asset, such as the creditworthiness of the borrower or the regulatory environment in which the company operates.
6. Difficulty in determining an accurate price-to-earnings (P/E) ratio. This is because P/E ratios are based on historical earnings and may not reflect future performance.
7. Difficulty in determining an accurate price-to-book ratio (P/B). This is because book values may not accurately reflect asset values due to depreciation and amortization.
Conclusion
Intrinsic valuation is an important skill for any investor to have, and an important way to make the right decisions regarding an investment venture. Intrinsic valuations should be completed by performing fundamental analysis, which consists of performing research on the topic in question, auditing the firm's balance sheet, and analyzing its competitive position. It's also essential to perform both quantitative and qualitative analysis when using intrinsic valuation. The crux of intrinsic valuation is determining what a company is worth, on its own merits and without factoring in market trends or conditions, which can be highly volatile.
Intrinsic valuation is an effective way to analyze a potential investment. As has been readily discussed, it emphasizes the underlying health of the company. For this reason, it is more useful than traditional financial analysis to determine whether a company has substantial value long term.
Key Takeaways
Intrinsic valuation uses fundamental analysis while discounting market prices to find the true value of a company's shares.
Intrinsic valuation is used by investors to determine the true value of an investment based on individual analysis of that investment, rather than on market trends.
It is essentially a combination of a company's fundamentals and how it's expected to perform in the future.
Each method has its pros and cons, and you should use them in conjunction with one another to get a full picture of where your investments stand.
You can read our other blogs here:
5 Benefits of Relative Valuation with Formula and Example
Discounted Cash Flow Valuation: What, How, and Methodology in 4 Easy Steps