Beyond Market Price: How to Calculate Intrinsic Value

 How to Calculate Intrinsic Value

Intrinsic value is a key idea in finance and investing. It helps investors figure out the real worth of an asset by looking at its basic qualities, not just its current market price. Here are some main ways to calculate intrinsic value. 

This value is estimated using different methods that try to measure the future benefits an investment might bring. Key methods include:

How to Calculate Inristinsic Value?

• Discounted Cash Flow (DCF) analysis: Calculates the present value of expected future cash flows.
• Price-to-Earnings (P/E) ratio: Compares a company’s current share price to its earnings per share.
• Price-to-Book (P/B) ratio: Compares a company’s market value to its book value.
• Price-to-Sales (P/S) ratio: Compares a company’s stock price to its revenues.
• Enterprise Value to EBITDA (EV/EBITDA): Compares a company’s total value to its earnings before interest, taxes, depreciation, and amortization.

Discounted Cash Flow (DCF) Analysis:

Discounted Cash Flow (DCF) analysis: is a popular method to find out the true value of a company or asset. Here’s a simple explanation:

• What It Does: DCF estimates how much money a company will make in the future.
• How It Works: It adds up all the future cash flows (money coming in) the company is expected to generate.
• Discount Rate: These future cash flows are then “discounted” back to their value today using a discount rate. This rate reflects the cost of capital or the return investors expect, considering the risk involved.

Why It’s Important: The idea is that the value of a business today is the total of all its future cash flows, adjusted to their present value. This helps investors decide if an investment is worth it.

Steps in DCF Analysis:

• Forecasting Cash Flows

  Forecasting Cash Flows: is the first step in Discounted Cash Flow (DCF) analysis. Here’s a simple explanation:

  • What It Means: Forecasting cash flows means predicting how much cash a company will have in the future.
  • Free Cash Flows (FCF): This is the cash left over after the company has paid all its expenses and reinvested in its business.
  • Why It’s Important: This cash is available to investors, so knowing how much there will be helps in valuing the company.

  Example: Imagine a company makes $1 million in revenue. After paying all its bills and reinvesting in new equipment, it has $200,000 left. This $200,000 is the free cash flow.

• Choosing a Discount Rate

  Choosing a Discount Rate is the next step in Discounted Cash Flow (DCF) analysis. Here’s a simple explanation:

  • What It Means: The discount rate is a percentage used to calculate the present value of future cash flows. It helps determine how much future money is worth today.
  • Why It’s Important: It accounts for the riskiness of the investment. Riskier investments need a higher discount rate because there’s a greater chance the future cash flows won’t be as expected.

  Weighted Average Cost of Capital (WACC): This is a common discount rate used in DCF. It represents the average rate of return a company is expected to pay its investors (both equity and debt holders).

  Example: Imagine you expect to receive $100 in a year. If the discount rate is 10%, the present value of that $100 is about $90.91 today. This means $100 in the future is worth $90.91 today, considering the risk and time value of money.

• Calculating Present Value

  Calculating Present Value is the final step in Discounted Cash Flow (DCF) analysis. Here’s a simple explanation:

  • What It Means: This step involves figuring out how much future cash flows are worth in today’s money.
  • How It’s Done: You take the future cash flows you forecasted and use the discount rate you chose to find their present value.

  Why It’s Important: Money today is worth more than the same amount in the future due to risks and the potential to earn interest. By calculating the present value, you can see how much future earnings are worth right now.

  Example: Imagine you expect to receive $100 in a year. If your discount rate is 10%, the present value of that $100 is about $90.91 today. This means that $100 a year from now is worth $90.91 today when considering the risk and time value of money.

• Terminal Value

  Terminal Value is an important part of Discounted Cash Flow (DCF) analysis. Here’s a simple explanation:

  • What It Means: Terminal value estimates the value of a company beyond the forecast period, into the future.
  • Why It’s Important: It accounts for the company’s value after the specific forecast period ends, ensuring the analysis includes all future cash flows.

  How It’s Done:

  1. Calculate Terminal Value: Estimate the company’s value at the end of the forecast period.
  2. Discount to Present Value: Use the discount rate to find out how much this future value is worth today.

  Example: Imagine you forecast a company’s cash flows for the next 5 years. But the company will continue to operate beyond those 5 years. Terminal value helps estimate the company’s worth after those 5 years. Then, you discount this value to see how much it is worth in today’s money.

• Summing the Present Values

  Summing the Present Values is the final step in Discounted Cash Flow (DCF) analysis. Here’s a simple explanation:

  • What It Means: This step involves adding up all the present values of the projected future cash flows, including the terminal value.
  • Why It’s Important: By summing these values, you get the total intrinsic value of the company or asset.

  How It’s Done:

  1. Calculate Present Values: Find the present value of each future cash flow using the discount rate.
  2. Include Terminal Value: Add the present value of the terminal value to these cash flows.
  3. Sum Them Up: Add all these present values together to get the intrinsic value.

  Example: Imagine you have calculated the present values of future cash flows for the next 5 years and the terminal value. By adding these present values together, you get the total intrinsic value of the company today.

DCF analysis works best for companies with steady and predictable cash flows. However, it can be tricky because it relies on assumptions about growth rates and discount rates. This means you need to be very careful with the data you use.

Price to Earnings (P/E) Ratio

Simplified Explanation of the P/E Ratio

The Price-to-Earnings (P/E) ratio is a simple and popular way to value a company, especially public ones. It shows how much investors are willing to pay for each dollar of a company’s earnings. Here’s how it works:

What is the P/E Ratio?

Key Points about the P/E Ratio:

• High P/E Ratio: This might mean the stock is expensive, or investors expect the company to grow a lot in the future.
• Low P/E Ratio: This could mean the stock is cheap, or the company’s future earnings might not be strong.

Limitations:

• Ignores Debt and Cash Flows: The P/E ratio doesn’t consider how much debt a company has or its cash flow.
• Cyclical Earnings: It can be misleading for companies with earnings that go up and down a lot or those that reinvest heavily in growth.

How to Use It:

Investors often compare a company’s P/E ratio to those of similar companies or the market average to see if it’s fairly priced. While it doesn’t give a precise value like DCF analysis, the P/E ratio is a handy tool for quickly evaluating stock prices.

Conclusion

Intrinsic value is a crucial concept in finance and investing. It helps investors determine the true worth of an asset by examining its fundamental qualities, rather than just its current market price. There are several methods to estimate this value, each aiming to measure the future benefits an investment might provide.