Table of Contents
What Is Intrinsic Value?
Intrinsic value is a measure of an asset’s worth based on an objective calculation rather than a relative valuation. Intrinsic value, also called true value or fundamental value, is different from market value, which can shift as demand for an asset rises or falls or as comparable assets’ values shift. However, intrinsic value shifts only as the asset’s own performance shifts.
Intrinsic value is the basis of value investing, an investment strategy founded by Benjamin Graham and further popularized by Warren Buffett. These two renowned investors advocate for buying stocks with a market value or market price below the intrinsic value.
Key Takeaways
- Intrinsic value is a measure of an asset’s worth based on an objective calculation rather than a relative valuation.
- Intrinsic value is the basis of value investing, an investment strategy involving buying stocks with a low market price compared to intrinsic value.
- Using spreadsheets to calculate intrinsic value will help speed up the process.
- To be the most effective investor, it’s important to understand multiple valuation methods, in addition to the intrinsic valuation method.
Why Is Intrinsic Value Investing Valuable?
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses.”
WARREN BUFFETT
This system provides a systematic and objective way to estimate the value of an asset, which can lead to more informed and effective decisions. By using the intrinsic valuation method, investors can avoid emotional or irrational decision-making and base their investment decisions on a solid understanding of the underlying value of an asset.
Important
While the goal in calculating intrinsic value is to be objective, it’s important to remember it is still an estimate. While it aims to prevent irrational decisions, it cannot completely eliminate risk in investing.
How to Calculate Intrinsic Value
Investors calculate intrinsic value using a few different methods, but the most common is the discounted cash flow method. This method is useful because it captures the present value of an investment using its future cash flows and adjusting for the time value of money.
The formula can get pretty long and complicated when calculating discounted cash flows. It looks like this:
[Cash flow of period 1 / (1 + discount rate)1] + [Cash flow of period 2 / (1 + discount rate)2]….[Cash flow of period n / (1 + discount rate)n] + [Terminal value / (1 + discount rate)n]
Simple Break Down of the Formula
Step 1: Find the cash flow of each period.
Multiply cash flow from the previous year by (1 + growth raten). Your formula will look like this:
Cash flow year 0 x (1 + growth raten)
“N” represents the period. For example, in year two, “n” will equal two.
Step 2: Find the discounted cash flow of each period.
Take the cash flow from each year you calculated in Step 1, and divide by (1 + discount raten). Here’s what your formula will look like:
Cash flow of year n / (1 + discount raten)
The discount rate can either be the company’s weighted average cost of capital (WACC), if you have it, or a risk-free rate. Investors commonly use the interest rate on a 30-year treasury bill as the risk-free rate.
Step 3: Find the sum of all discounted cash flows.
Add each discounted cash flow that you found in Step 2 together.
Step 4: Find the terminal value.
The terminal value is an estimate of the future value of an asset beyond the forecasting period used in the analysis. The terminal value provides a rough estimate of the long-term value of the asset, which is useful in determining whether an investment is undervalued or overvalued.
While there are multiple methods for finding terminal values, we’ll use the exit multiple method. This method assumes that the asset will be sold for a multiple of its cash flows at the end of the forecasting period. The terminal value is calculated by multiplying the terminal year’s cash flow by the exit multiple.
The exit multiple is a measure of the cash flows an asset is expected to fetch when it is sold or liquidated. The exit multiple should be chosen carefully and based on industry averages, comparable transactions, and the expected future performance of the asset.
Use the following formula to calculate:
Terminal value = (Cash flow of final period x exit multiple) / (1 + discount raten)
Step 5: Add terminal value to the sum of the discounted cash flows of years 1–10.
Combine the sum you found in Step 3 with the terminal value you found in Step 4 to get your final answer.
Example of Calculating Intrinsic Value of a Stock Using Discounted Cash Flows
In this example of what a discounted cash flow calculator looks like, we’ll use the earnings available to investors from the previous year as our cash flow in year 0. For Company XYZ, that number is $280. Company XYZ’s growth rate is 5%. We’re going to look at a period of 10 years.
Cash flow year 0 = $280
Growth rate = 5%
Step 1: Find the cash flow of each period.
| Year | Calculation Cash Flow of Year 0 x (1 + Growth Raten) | Cash Flow |
| Year 1 | 280 X 1.051 | $294.00 |
| Year 2 | 280 X 1.052 | $308.70 |
| Year 3 | 280 X 1.053 | $324.14 |
| Year 4 | 280 X 1.054 | $340.34 |
| Year 5 | 280 X 1.055 | $357.36 |
| Year 6 | 280 X 1.056 | $375.23 |
| Year 7 | 280 X 1.057 | $393.99 |
| Year 8 | 280 X 1.058 | $413.69 |
| Year 9 | 280 X 1.059 | $434.37 |
| Year 10 | 280 X 1.0510 | $456.09 |
Step 2: Find the discounted cash flow of each period.
We’ll use the current 30-year treasury bill interest rate for our discount rate. That number is 3.79%.
| Year | Calculation Cash Flow of Year n / (1 + Discount Raten) | Discounted Cash Flow |
| Year 1 | 294 / 1.03791 | $283.26 |
| Year 2 | 308.70 / 1.03792 | $286.57 |
| Year 3 | 324.14 / 1.03793 | $289.91 |
| Year 4 | 340.34 / 1.03794 | $293.29 |
| Year 5 | 357.36 / 1.03795 | $296.71 |
| Year 6 | 375.23 / 1.03796 | $300.17 |
| Year 7 | 393.99 / 1.03797 | $303.66 |
| Year 8 | 413.69 / 1.03798 | $307.21 |
| Year 9 | 434.37 / 1.03799 | $310.79 |
| Year 10 | 456.09 / 1.037910 | $314.41 |
| Sum = $2,985.96 |
Step 3: Find the sum of all discounted cash flows.
Our sum is $2,985.96 as calculated in the table above.
Step 4: Find the terminal value.
By looking at industry averages and comparable transactions, we’ve chosen an exit multiple of 15. Our calculation will look like this:
Cash flow year 10 x exit multiple / (1 + discount raten)
Cash flow year 10: $456.09
Exit multiple: 15
N = 10
Discount rate = 1.0379
$456.09 x 15 / 1.037910 = $4,716.15
Terminal value = $4,716.15
Step 5: Add terminal value to the sum of the discounted cash flows of years 1–10.
$4,716.15 + $2,985.96 = $7,702.11
Intrinsic Value = $7,702.11
Compare the intrinsic value of $7,702.11 to the current market price of the asset. If the asset is trading for under $7,702.11, this stock is undervalued and a good stock to buy.
Determining Intrinsic Value Using Spreadsheets
As you can see, calculating intrinsic value has a lot of steps. It can take a lot of your time if you try to do all the calculations by hand. Let Excel or Google Sheets speed up the process for you. The great thing about calculating intrinsic value with a spreadsheet is that once your formulas are set up, you can simply plug in new numbers each time you want to calculate a new value.
Here’s how you’ll set up your spreadsheet:
Steps to Set Up Your Spreadsheet
Step 1: Find the cash flow of each period.
- The formula in cell C2 looks like this: =$D$2*($E$2^A2).
- You’ll then drag that formula down through cell B11.
Step 2: Discover the discounted cash flow of each period.
- The formula in cell B2 looks like this: =B2/$F$2^A2
- You’ll then drag that formula down through cell C11.
Step 3: Calculate the sum of all discounted cash flows.
- The formula in cell C12 looks like this: =sum(C2:C11)
Step 4: Find the terminal value.
- The formula in cell C13 looks like this: =(B11*G2)/(F2^A11)
Step 5: Add the terminal value to the sum of the discounted cash flows of years 1–10.
- The formula in cell C14 looks like this: = C12+C13
Now that your spreadsheet is set up, you can change out your cash flow, growth rate, discount rate, and exit multiple to find the intrinsic value of other assets.
Other Types of Analysis to Use When Intrinsic Value Isn’t Reliable
The intrinsic valuation method isn’t perfect, especially when an asset does not have cash flows, such as commodities like gold or an undeveloped piece of land. The intrinsic valuation method would say these commodities have no intrinsic value. Companies that have yet to produce a positive cash flow would also appear to have no intrinsic value using this calculation. While these assets could have some intrinsic value, there is no way to accurately calculate it.
When you can’t use intrinsic value to calculate an asset’s worth, you’ll need other valuation methods. Additionally, it’s useful to use other valuation methods in conjunction with the intrinsic valuation method when making investment decisions. The more information you have, the better an investor you will be.
Try these alternative valuation methods:
- Relative valuation: This approach compares the value of an asset to similar assets in the market.
- Real options valuation: This method incorporates the value of flexibility and the option to take different actions in response to changes in the market or business environments.
- Multiples analysis: This approach uses multiples of financial metrics such as earnings, cash flows, or revenues to estimate the value of an asset.
- Market valuation: This approach looks at the current market price or share price of an asset as the best estimate of its value. This assumes that markets are efficient and that the current price reflects all available information about the asset.
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