Definition:

1. 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.
2. 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:

1. Dividend Discount Model. (DDM)

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+ …….+D_n/(1+r)ⁿ  +P_n/(1+r)ⁿ

Whereby,

D - Expected Dividend in the given year.

r- Required rate of return.

P_n= (D_n+1 )/(r-g₎

Limitations of this is that it will not work for companies that do not pay dividends.

For Constant Dividends:

P=D_t / r where:

Whereby,

P - Intrinsic value

D_t- Expected dividend

r- Appropriate discount factor for the investment

This method is useful for analysing preferred shares where the dividend is fixed.

2. Gordon Growth Model.

This is a type of DDM and assumes that the business has a steady growth, mostly industries in the mature stage.

It is calculated as;

Value of Stock= D/ r-g

Whereby,

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.

3. Discounted Cash Flow Model.(DCF)

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 +……+CF_n/(1+d)ⁿ

Whereby,

CF_n- 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.

4. Residual Income Model

This is the use of readily available information from the financial statements to calculate the intrinsic value.

Value of the Stock = B₀ +∑ (EPS- r) B_n-1/(1+r)ⁿ

Whereby,

B₀- Current per Share Book Value

B_n-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.