The market price of a stock is influenced by the demand and supply for it, which means that at any particular point in time, the price will not always reflect its true worth, therefore as an investor, it’s important to know if you are getting a bargain or a rip-off.
Intrinsic value can be defined as an estimate of a company’s worth. Warren buffet defined it as the discounted value of the cash that can be taken out of a business during its remaining life.
How to Calculate Intrinsic Value
The concept of intrinsic valuation was proposed by Benjamin Graham in his 1934 book security analysis however since then other analysts and investors have developed similar iterations of that formula.
For this post, I will consider 4 different iterations of the intrinsic value formula, namely:
- The Benjamin Graham formula
- Growth Modification of The Benjamin Graham Model
- Discounted model
- Discounted model using free cash flows
1. The Benjamin Graham Model
In developing the intrinsic value formula ben Graham was trying to establish a stock’s value based on earnings and earnings growth while keeping an eye on bond yields available as an alternative.
You see, bond yields are an important valuation and pricing factor for value investors. The idea is that to justify the added risk, “a stock’s return should be reasonably higher than that of an ordinary bond, if not why not just buy a bond and rest easy.“
Benjamin Graham’s formula requires a combination of the company’s current earnings, a base P/E ratio, a growth factor, and an adjustment according to the current bond yield. See below:
Intrinsic value = EPS * [(2 growth rate) + 8.5] * [4.4/bond yield]
Were:
EPS = the current annual earnings per share.
growth rate = is the annual earnings growth rate of the business, usually for the next 5 years (See how to estimate growth rates here)
8.5 = the Benjamin Graham assumed base P/E ratio for a stock with no growth.
4.5 = Benjamin Graham assumed average yield of AAA corporate bonds.
Y = Current yield of AAA corporate bond. (find this here)
Note: The lower the bond rates the higher the intrinsic value. This is because future earnings streams are worth more in a lower interest rate environment.
2. Growth Modification of The Benjamin Graham Model
Many investors today believe that the growth part of the ben graham formula (2 (growth rate) + 8.5) is far too aggressive and a more realistic price to earnings base for a no-growth company should be: (growth rate + 7).
With those adjustments, the new formula then becomes:
Intrinsic value = EPS * [growth rate+ 7] * [4.4/bond yield]
3. Discounted Model
You already know that inflation is the bad guy that makes a dollar today worth less than a dollar in two years. So if an investment requires you to pay $350 for a return of $370 in 3 years, you would consider what that $370 would be worth in today’s terms before accepting the deal.
With that idea in mind, value investors developed a method of calculating the intrinsic value of shares that also factors in future values.
To do that you’ll need:
growth rate = the company’s growth rate (usually for the next 5 years)
EPS ttm = the current annual earnings per share
P.E = Price earnings ratio
Rate of return = a percentage estimating expected gains on an investment. See how to estimate returns.
Next follow these steps:
- Use the growth rate and the current year earnings per share to estimate the future earnings on a company’s share.
- Multiply that figure by the price earnings ratio to get the future value
- Use your rate of return to discount the future value to today’s terms.
- Next apply a reasonable margin of safety (more on this later)
See this process in action on YouTube channel ‘Investing with Tom‘:
4. Discounted Model using Free Cash Flows
This method is similar to the one in 3 above except that instead of using eps you would use the company’s free cash flow instead.
You can find the free cash flow figure in the company’s cash flow chart on Gurufocus.
See proccess in action by YouTube channel: ‘Cooper Academy’
Margin of safety
Value investors are bargain hunters; this means that they only buy a share when it’s worth less than its intrinsic value. The idea is to be in profit the very moment they enter the trade. They achieve this through a margin of safety.
Margin of safety is the difference between what a company is worth and what you are willing to pay for it.
After calculating a company’s intrinsic value, you need to decide what your margin of safety would be, most times this decision is based on how much faith you have in the company’s future growth. This faith is usually influenced by the qualitative factors surrounding the company, e.g. the management style, its competitors, government policies etc.
Price is What we Pay, Value is What we get
A common criticism of buying and holding a company’s share at a bargain price is that the business value may drop below that level and then markets align to that price or lower, effectively leaving you at a loss. To avoid this scenario you must make sure that the business is not just cheap, it should also be highly productive and efficiently managed.
Factors that would influence this decision are called qualitative factors. I consider qualitative factors in my next post.
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