Everything You Need to Know About the Intrinsic Valuation of Shares

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:

1. The Benjamin Graham formula
2. Growth Modification of The Benjamin Graham Model
3. Discounted model
4. 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:

1. Use the growth rate and the current year earnings per share to estimate the future earnings on a company’s share.
2. Multiply that figure by the price earnings ratio to get the future value
3. Use your rate of return to discount the future value to today’s terms.
4. 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.

Start With What You know: A Beginner’s Guide to Making Stock Investment Decisions

As of June 2022, the NYSE had a combined total of 2,584 listed domestic and international companies, so when someone tells you to invest in the stock market, where to begin, which industry, which companies or what shares? These are just a few of the questions that would begin to float through your mind.

Where to begin?

There are different theories on how to choose your first share investment but one thing almost everyone agrees on is that you should choose an industry you like and a business you love. As a shareholder who is also a customer/enthusiast, you’ll find it easier to read up on the company’s information, effectively equipping yourself with the ability to make a decision either to sell/buy/hold your investments.

Summary:  Go for businesses you like and whose products you already. Also, your investment portfolio can include as many industries as you want. In fact investing in multiple industries is a reliable way to manage your portfolio risks.

Incorporating Rational Analysis

After identifying your favourite companies, next you want to find out as fast as possible if the business is doing as well as you would think. In other words, you want to back up your favourite choice with an objective analysis without spending too much time on research.

This is where financial ratios and financial reports come in.

Listed companies are mandated to issue reports on their performance to the public, you can use information from these reports to conduct a quick analysis of the company.

Related: The Foundations of successful investments

Interpreting Financial Statements with Ratios

Over the years financial ratios have been developed to help investors interpret the numbers in a company’s account reports.  Financial ratios are  grouped into:

1. Profitability ratios
2. Liquidity ratios
3. Efficiency/activity ratios
4. Long-term solvency/Leverage ratios
5. Investment ratios

Profitability ratios 

These ratios are used to assess the level of profitability of a business entity in relation to the revenue generated and the capital invested.  Examples include:

• Return on capital employed (ROCE)
• Return on equity (ROE)
• Gross profit margin
• Net profit margin

Liquidity/Financial strength ratios

These are ratios that measure the ability of a business entity to meet its short-term obligation, that is pay its day-to-day debts as they fall due by using assets that can be quickly converted to cash.

These assets are normally referred to as liquid assets and they are shown in the statement of financial position as current assets. They are also referred to as working capital.

The ability of the company to utilize its long-term resources in its day-to-day operations depends on the adequacy of its working capital. The difference between these current assets and the company’s short-term obligations, current liabilities, is known as net working capital.

Examples include:

• Current ratio
• Quick assets ratio
• Absolute liquid ratio
• Net operating cycle
• Number of inventory days
• Number of receivable days
• Number of payable days

Efficiency/ Activity ratios

These ratios measure how efficiently the business entity has been utilizing its assets.

How much inventory, accounts receivable, or fixed asset investment does it take to support a given volume of business? Are these assets being managed effectively with proper controls?

Examples include        

• Total asset turnover
• Net assets turnover
• Trade receivables turnover
• Inventory turnover

Long-term Solvency/Leverage Ratios

These are ratios that show the capital structure of a business entity. They show the mixture of the business capital between equity (proprietary capital) and debts (long-term liabilities). They provide information on the degree of a company’s fixed financing obligations and its ability to satisfy these financial obligations.

Examples include

• Capital gearing
• Debt to Equity ratio
• Interest cover

Investment Ratios/Valuation ratios  

These are ratios that are of interest to investors and potential investors. They show the level of returns that an investor can expect from investing in the business entity. They are also referred to as shareholder ratios.

With valuation ratios, the stock price enters the picture. Valuation ratios, as the name implies, relate a company’s stock price to its performance. The ubiquitous price to earnings (P/E) ratio shows up here, as does its sibling’s price to sales (P/S), price to book (P/B), and a few others.

• Earnings per share
• Price earnings ratio (P/E ratio)
• Dividend Cover
• Dividend yield

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Ratio Information Sources

The figures you need for your ratio analysis are found in the company’s financial statements (specifically the income statement and statement of financial position) which are part of a company’s annual report.

You can find a company’s annual reports on yahoo finance or do a quick google search with the company’s name, the year you require plus annual reports.

Where can you find computed ratios online?

It’s true that anybody with a company’s annual reports and a calculator can calculate a company’s ratios, however, I must admit that ratio analysis can be cumbersome and time-consuming, particularly when you’re looking at a group of companies or industries. So where can you find services that do the work for you for free?

• Yahoo finance (no registration required)
• Investopedia Stock Simulator (free registration)
• Trading 212 (free registration)

These are just the few that I use there are many others out there. If you know more kindly comment below!!!

What Do you look for When analyzing ratios?

• Consistency
• Trends
• Intrinsic meaning
• Competitive Comparisons

Consistency

The hallmark of good management, as well as of an attractive long-term investment, is the consistency of results delivered. If profit margins are consistent and changing at a consistent rate, the company is predictable — and most likely in control of its markets. Inconsistent ratios reflect inconsistent management, competitive struggles, and cyclical industries, all of which diminish a company’s intrinsic value.

Trends

Better than consistency alone is consistency with a favourable trend. Growing profit margins, return on equity, asset utilization, and financial strength are all very desirable, particularly if valuation ratios (P/E and so on) haven’t kept pace. Value investors who study trends carefully have information that most investors don’t have.

Comparisons

 For many analysts, and especially credit analysts, who are trying to get a picture of a company’s health, a comparative analysis is the most important use of ratios. A ratio acquires more meaning when it’s compared to direct competitors, the company’s industry, or much broader standards, like the S&P 500.

A profitability measure, such as gross profit margin, reported at 25 percent tells more when direct competitors are at 35 percent plus.

Note: Beware of differences within industries when comparing companies. A company mostly in the health insurance business may be difficult to compare to a company that sells mostly life insurance. While the resulting ratio differences may in part be valid, they also may lead you to believe that an apple is bad when it really isn’t. It’s important to compare apples to apples when comparing different companies.

Intrinsic Meaning

 What does the ratio tell you?

• If the debt-to-equity ratio is 3 to 1, then the company has a lot of debt.
• If the inventory-to-sales ratio is greater than 1, then the company turns its inventory less than once per year.
• A P/E ratio of 50 implies a 2 percent return on invested capital ($1 returned per $50 invested).

These numbers tell you something without looking at any comparisons or trends. Want an early test for determining whether a ratio is good, bad, or ugly? Just think of the company’s ratio as it would apply to your personal finances.

A household with 3 times as much debt as equity is in dire straits, as is a household that turns over inventory (say, groceries) only once a year, as is a household that achieves only a 2 percent return on its investments, or a household that’s owed a third of its annual income. You can’t apply this test to all ratios, but where common sense tells you something, use it!

Now you know

Now you know the importance of financial ratios, and where to find them in minutes!! and what to do with them.

Did you enjoy this article? Do you have any questions or corrections feel free to comment below!!! I love to hear from you.

Related: How to estimate the benefits of investing in a company.

Where Do You Go From Here

Analyzing the performance of a company is one of the considerations you make before you decide to invest in them. Next, you have to find out if they are priced correctly, a high-performing company with overpriced shares is not exactly a good investment. Find out more in my next post.