Usually when people invest in a stock, they only focus on market price of the stock. But, successful investors understand that the market price of the stock doesn’t reflect true or fair value of the company. Investors determine the value of the stock by the help of intrinsic value concept.

Many big investors built their success by buying stocks when they were trading below the intrinsic value. It is the most important concept in value investing which was introduced by Benjamin Graham (The Father of value investing).

Through this blog, we will know

• What is Intrinsic value?
• Why it is important?
• How investors estimate the intrinsic value of a stock?
• What are its challenges while calculating Intrinsic ?

What is Intrinsic value?

Intrinsic value means the true or fair value of a stock based on the company financial performance, assets, future cashflows and overall business potential.

Basically, Intrinsic value answers this question:

“What is the actual worth of the company”

the stock price changes everyday dues to demand and supply, Traders Emotion, news and speculation. However, it focuses on the underlying strength of the business rather than short-term market hype.

If the intrinsic value of the stock is higher than the market price then it Is considered as undervalued stock.

If the intrinsic value of the stock is lower than the market price then it is considered as overvalued stock.

This concept was widely used in the value investing, a strategy popularized by investors like Benjamin Graham and also his student Warren Buffet.

Why It is important for investors?

Instead of buying stocks based on short term hype or trends, investors can evaluate whether a company is worth its price.

Here are some points why it matters:

• Identifying Undervalued stocks

Investors can find and buy a stock which is traded below the intrinsic value until market recognizes its true price.

• Reducing Investment risk

Understanding can reduce risk to avoid paying stocks which is not worth.

• Long-Term Investment Strategy

It help picks up that stocks that which has strong fundamentals rather than short-term price movements.

• Margin of Safety

Investors who understands intrinsic value, buys stock under the market price. That difference is known as margin of safety. This is illustrated in the above image

How Investors estimate Intrinsic Value of a stock?

There are several methods to find intrinsic value. Each methods have its own assumptions and limitations.

Below are some of the most commonly used methods to calculate:

Discounted Cashflow method (DCF)

It is one of the widely used method to calculate. This method estimates the value of the company by calculating the present value of its future cash flows.

Income received in future is worth less than income received today because of inflation.

Below is the formula to DCF:

Intrinsic value=Sum of all future cashflow discounted to present value

To get Intrinsic value using DCF, Investor need to estimate:

• Future Cashflow
• Discounted rate
• Discount rate
• Terminal value

To get true value of the business using DCF model, you need to have several assumptions about the company's future performance.

Price-to-Earning (P/E) Valuation

Another method is using the Price-to-Earning (P/E) ratio. It is also one of the famous or common to calculate.

Below is the formula of Price-to-Earning (P/E)

Intrinsic value= Earning per share * Expected P/E ratio

for example:

let's take an example of A company in which market price of the stock is ₹120 and the company earns ₹10 per share and expected P/E ratio is 15

Intrinsic value= 10 × 15 = ₹150

And the Market price is ₹120 and the company intrinsic value is ₹150, then the stock is considered as undervalued.

Asset-based Valuation

In asset-based valuation, investors estimate the value of a company based on its asset minus liabilities

Below is the formula of Asset-based valuation

Intrinsic value= Total Assets - Total Liabilities

This method is mostly commonly used for companies in industries such as banking, real estate, or manufacturing where physical assets plays an important role.

What are its challenges while calculating Intrinsic?

As it is an important concept, calculating it is not always easy or you can say not everyone cup of tea.

There are several challenges faced by investors while calculating such as:

• Future Uncertainty: Predicting future earnings and cash flows can be difficult.
• Assumptions and Estimates: Different assumptions can lead to very different valuations.
• Market Behavior: The market may remain irrational for long periods of time.

As one of the famous Investor and Businessman Warren Buffet said:

"Price is what you pay. Value is what you get."

This Quote highlights the difference between market price and True value of the business.

Conclusion:

Intrinsic value is the most powerful important concept in investing, It allows investors to look beyond short-term hype and focus on the true or fair value of the business.

Although calculating is based on assumptions and careful analysis. It provides a discipline decision for making long term investments.

Investors who consistently buys stock whose market price is below Intrinsic value increases the chance of achieving long-term success in the stock market.