Intrinsic Value of a Company: What are the various valuation methods?

Intrinsic Value of a Company

Intrinsic value is the probable or anticipated value of company stocks, products, currency, etc., and this value is determined through fundamental analysis. Determining the intrinsic value includes both intangible and tangible factors. The intrinsic value is also known as real value (which may or may not equal the current market value of stocks). Rational investors are willing to pay this amount in order to gain a return on investment along with the associated risk.

Intrinsic Value of a Company: Basic Formula

With the help of intrinsic value a shareholder, investor, or financial analyst can measure the actual worth of any asset available in the market. In order to derive the real value of the asset, investors use complex economic models and objective calculations instead of depending on the present market price of the same asset.

Although there is no particular standard for calculating the intrinsic value of any company, financial analysts use different valuation models depending upon the entire business aspect and the industry. The valuation model also includes perceptual, quantitative, and qualitative factors.

The most standard approach towards intrinsic value is based upon the formula of net present value:

The usual meaning of the symbols is presented below:

n = number of periods

NPV = Net Present Value

r = interest rate

CFi = Net cash flow for the ith period (for the first cash flow, i = 0)

Dissecting the intrinsic value

As mentioned earlier, value investors and financial analysts use fundamental analysis in order to calculate the intrinsic or real value of a company. While measuring the real value, analysts and investors evaluate both the qualitative and quantitative factors. 

The qualitative factors in the fundamental analysis include market factors, governance, business model, etc. On the other hand, the quantitative factors include the evaluation of financial statements. After calculating the intrinsic value, it is compared with the market in order to find out if the security or asset is overvalued or undervalued.

Intrinsic Value of a Company: Risk Adjustments

Adjusting or regulating the risk of cash flow is purely subjective and it is considered both a combination of science and art. The two primary methods of risk adjustment are given below.

Discount rate

In this approach, the investors and analysts utilize a company’s average capital cost. Typically, the average capital cost of a company has a risk-free rate and it comes with a premium depending upon the instability of the stocks multiplied by an equity risk premium. 

The fundamental theory behind this formula is that if a stock is more dynamic, the investment can be riskier and the investor should receive better returns. Therefore, in these circumstances, a higher discount rate gets used and it can also decrease the cash flow value in the near future.

Certainty Factor

In this process, a probability or certainty factor is included in each cash flow and then it is multiplied against the total NPV or net present value. Through this method investments can be discounted and a risk-free rate is utilized as the discount rate to adjust the risk. 

For example, the government bond cash flow arrives with a 100 percent conviction, therefore the discount rate, in this case, would be 7 percent and both the yield and discount rate are equal.

Difficulties of intrinsic value

One of the most difficult factors with intrinsic value is the method of calculating the real value of any stock or security (which is extremely subjective). In order to project the cash flow, we need to include multiple assumptions in the calculation method. 

Therefore, the final NPV is also subject to changes because of these assumptions in the calculation. There are other important factors that we need to include in the calculation such as market risk premium, beta, etc. (which need to be calculated differently). The probability factor is also subjective.

All of us know that the future is uncertain, and that is why when we are using different methods to calculate the intrinsic value of an asset different investors and analysts may get different results (although they are calculating). The different result is because everybody looks at the future very differently and that is why we cannot conclude which number can be accurate.

Intrinsic Value of a Company: Valuation Methods

There are a total of three methods through which the industry practitioners measure the value of a company. There of them are:

• DCF analysis
• Precedent Transactions
• Comparable company analysis

Let us briefly discuss all of them below:

DCF Analysis

DCF or Discounted Cash Flow method is the most popular and utilized approach taken by investors and financial analysts in order to reach the real or intrinsic value of an asset. Through DCF analysis the investors predict the cash flow of the companies and deduce it to the current value by utilizing the WACC or Weighted Average Cost of Capital.

Now let us understand how DCF analysis works through an example. Suppose a company has the following cash flow:

Cash flow of the company for five years starting in 2022 = Rs. 200

Discount rate – 15%

Terminal Growth rate – 10%

The current estimation of the cash flow generated in 2022

= CF / (1+r)^n

= 200/ (1+15%)^1

Therefore, the current value is Rs. 174

Terminal value is computed as perpetual growth.

In this case the formula is  

= {CF*(1+growth rate)}/(discount rate – growth rate)

Therefore, the terminal value is

= {200*(1+10%)}/(15%-10%)

= Rs 400

The current worth of the terminal value is measured using the above-mentioned method.

Precedent Transactions

This particular method is homogeneous to the method of relative valuation. However, through the precedent transactions method, the investor or analyst compares a company with other businesses that have recently been acquired or sold while belonging to the same industry. In order to evaluate the financial worth of the company, the precedent transactions method is utilized.

Comparable Analysis

This method also has other names such as peer group analysis, public market multiples, trading multiples, and equity comps. In this method, the relative valuation of a company gets used to compare the assets or business with other trading multiples such as EBITDA, P/E ratio, etc. with the help of this method you can derive an observable value in comparison to other companies and businesses.

For example, if company X is being traded at a 20x P/E ratio and the earning per share of company Y is Rs. 4 then the value of the Y company stocks would be Rs. 40 per share (if the companies are entirely comparable).

Nevertheless, Intrinsic value is an important element of evaluating company stocks in order to determine your investment strategy. You can measure a reasonable amount using various methods but as an investor or financial analyst, you need to utilize the best method depending upon the characteristics of the company and its associated sector. 

Important things to remember:

1. Do Not Blindly Follow Hot Tips

No matter how credible the source is, never follow a stock marketing tip blindly without conducting thorough research personally. Always select the stocks after doing proper research and analysis on the performance as well as the companies. While some tips can work out to give you huge benefits, the wrong ones can push you down under the risk pretty quickly. 

2. Eliminate Loser Stocks from Portfolio 

There is absolutely no guarantee that a stock will rise after a great fall. Know that it is extremely important to be practical about what is possible and what's impossible in the stock market. So, upon realizing that a stock is performing poorly in your portfolio, accept your mistake and sell it immediately to prevent further losses. 

3. Don't Exceed Your Investment Budget Abruptly 

While it's true that long-term investments are way better than other forms of investment, you shouldn't exceed your investment budget in a haste. Instead, decide on a fixed amount and invest it across various good stocks. Rather than investing in only one stock, divide your budget evenly across multiple good-performing stocks and shares.