What is Intrinsic Value?
Intrinsic Value is the estimated worth of an asset following the objective analysis of its fundamentals and internal data – without reliance on external factors such as prevailing market pricing.
- What is the definition of intrinsic value?
- What are examples of intrinsic valuation methods?
- How can the intrinsic value of stocks be calculated?
- What are the pros/cons of intrinsic valuation approaches?
Intrinsic Value Definition
The basis of intrinsic valuation states that the value of an asset can be derived from assessing the asset internally.
For instance, the intrinsic value of a company’s shares can be approximated by assessing the underlying company’s:
- Revenue: Historical Trends, Key Drivers of Revenue, Future Growth Outlook
- Margin Profile: Historical Profit Margins (e.g. Gross Margin, Operating Margin, EBITDA Margin, Net Profit Margin), Opportunities for Cost-Cutting, Industry Averages, Future Spending Needs
- Competitive Advantage: “Economic Moat”, Competitive Landscape, Market Size & Market Share
In the context of corporate valuation, the intrinsic value of a company is estimated from its future cash flows, growth potential, and risk.
Intrinsic Value Method – DCF Model
The most common intrinsic valuation method is the discounted cash flow model (DCF).
The DCF approach calculates the present value (PV) of the company’s expected cash flows (i.e. discounted to the present date), which represents the intrinsic value of the company.
Intrinsic Value Formula
Value = Σ CF / (1 + r) ^ t
- CF: Future Cash Flows
- r: Discount Rate (WACC, Cost of Equity)
- t: Time Period
Here, all the future cash flows (CF) of the company are discounted using an appropriate discount rate (r) that factors in risk – and then adds all the discounted cash flows together.
Each DCF model relies significantly on discretionary assumptions.
While all assumptions are subjective, if the model assumptions are completely baseless, the estimated value of the company will be far off from its “true” intrinsic value.
- Intrinsic Value > Current Share Price: Undervalued – Potential Buy
- Intrinsic Value = Current Share Price: “Correct” Market Pricing
- Intrinsic Value < Current Share Price: Overvalued – Potential Short-Sell
Intrinsic Value Method – Dividend Discount Model (DDM)
The dividend discount model (DDM) values a company based on the present value (PV) of its future dividends, with assumptions regarding the dividend amount and growth rate.
The intuition behind the DDM is similar to the DCF, however, the major difference is that dividends are used as the cash flows.
Under the DDM, the dividends issued by a company are assumed to be representative of the company’s financial health and future outlook.
Intrinsic valuation methods – considering how the value obtained is largely independent of market pricing – can uncover undervalued investment opportunities for investors to profit from the mispricing.