Understanding Intrinsic Value: A Beginners Guide to Value Investing

One of the most important concepts to understand when investing in stocks is intrinsic value. Intrinsic value is the true value of an asset or investment, based on its fundamental characteristics, and is often used by investors to determine whether a stock is overvalued or undervalued.

In this article, we will explain the concept of intrinsic value, how it differs from market value (Market Cap), and how to calculate it using various methods. We will also provide examples of Indian companies to help illustrate these concepts

What is Intrinsic Value and Market Value?

Intrinsic value is the actual value of an asset or investment, based on its fundamental characteristics such as cash flow, assets, liabilities, and growth prospects.

It is often calculated using fundamental analysis, which involves examining a company’s financial statements to evaluate its business operations and future prospects.

Intrinsic value can be thought of as the true value of an investment, regardless of what the market may be willing to pay for it.

On the other hand, market value is the price at which an asset or investment is traded in the market. It is the price that buyers and sellers agree on based on supply and demand.

Market value can be influenced by a wide range of factors, including economic conditions, political events, and investor sentiment.

Examples of Intrinsic Value and Market Value :

To better understand these concepts, let’s consider two examples of Indian companies: Reliance Industries and Tata Consultancy Services (TCS).

As of March 2023, Reliance Industries has a market value of approximately Rs. 14,00,000 crore, while TCS has a market value of approximately Rs. 14,50,000 crore.

However, the intrinsic value of these companies may be different from their market value.

For instance, Reliance Industries has a diversified business portfolio, including oil and gas exploration, petrochemicals, retail, and telecommunications. By using fundamental analysis, an investor may calculate that the intrinsic value of Reliance Industries is higher than its market value, indicating that the stock may be undervalued.

In contrast, TCS has a leading position in the IT industry and a robust financial performance, which may make it an attractive investment option for many investors, even if its market value exceeds its intrinsic value.

Difference Between Intrinsic Value and Market Value:

The main difference between intrinsic value and market value is that intrinsic value is based on fundamental characteristics, while market value is determined by the forces of supply and demand in the market.

Intrinsic value is calculated using financial analysis, while market value is determined by the prevailing market conditions.

Intrinsic value reflects the true value of an investment, while market value may be overvalued or undervalued based on market conditions.

Methods for Calculating Intrinsic Value:

Discounted Cash Flow (DCF) Analysis:

DCF analysis estimates the future cash flows of a company and discounts them to their present value to calculate the intrinsic value. This method is widely used in valuation, but it requires assumptions about future cash flows, which may be uncertain.

Example: Let’s say we want to calculate the intrinsic value of HDFC Bank. We estimate the future cash flows of the bank for the next ten years and discount them to their present value. If the calculated intrinsic value is higher than the market price, the stock may be undervalued.

Price-to-Earnings (P/E) Ratio:

P/E ratio compares the company’s current stock price with its earnings per share (EPS) to determine whether the stock is overvalued or undervalued. This method is simple to use, but it doesn’t account for a company’s growth prospects.

Example: Suppose we want to calculate the intrinsic value of Infosys. We divide the current market price of Infosys by its EPS to calculate the P/E ratio. If the calculated P/E ratio is lower than the industry average, the stock may be undervalued.

Price-to-Book (P/B) Ratio:

P/B ratio compares the company’s current stock price with its book value per share (BVPS). BVPS is the company’s assets minus its liabilities, divided by the number of outstanding shares.

This method is useful for valuing companies with tangible assets, but it doesn’t account for intangible assets such as brand value and intellectual property.

Example: Let’s say we want to calculate the intrinsic value of Tata Steel. We divide the current market price of Tata Steel by its BVPS to calculate the P/B ratio. If the calculated P/B ratio is lower than the industry average, the stock may be undervalued.

Dividend Discount Model (DDM):

DDM estimates the intrinsic value of a company by discounting its future dividends to their present value. This method is useful for valuing companies with a history of consistent dividend payments, but it doesn’t account for growth prospects.

Example: Suppose we want to calculate the intrinsic value of Reliance Industries. We estimate the future dividends of the company and discount them to their present value. If the calculated intrinsic value is higher than the market price, the stock may be undervalued.

Comparable Company Analysis (CCA):

CCA compares the company’s key financial metrics with those of similar companies to determine whether the stock is undervalued or overvalued. This method is useful for valuing companies in the same industry, but it requires a thorough understanding of the industry.

Example: Let’s say we want to calculate the intrinsic value of HCL Technologies. We compare the company’s P/E ratio, P/B ratio, and other financial metrics with other similar companies in the IT industry to determine if the stock is undervalued or overvalued.

Comparing Intrinsic Value and Market Value:

When calculating intrinsic value, investors may find that the calculated value is higher or lower than the current market price. If the intrinsic value is higher than the market price, the stock may be undervalued and could be a good investment opportunity.

Conversely, if the intrinsic value is lower than the market price, the stock may be overvalued, and investors may want to consider selling their shares.

However, it is important to note that market value can be influenced by various factors such as economic conditions, political events, and investor sentiment. Therefore, it is crucial to consider both intrinsic value and market value when making investment decisions.

Conclusion:

Calculating intrinsic value is an essential tool for beginner investors to make informed investment decisions. While there are several methods for calculating intrinsic value, each has its pros and cons. Investors should carefully evaluate the different methods and consider the company’s growth prospects, financials, and industry trends before making investment decisions.

By considering both intrinsic value and market value, investors can identify undervalued and overvalued stocks and make informed investment decisions that align with their investment goals and risk tolerance. As with any investment, it is crucial to do your research and seek professional advice before making any investment decisions.

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