What is Intrinsic Value?

What is Intrinsic Value?
Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an objective calculation or complex financial model, rather than using the currently trading market price of that asset. In financial analysis this term is used in conjunction with the work of identifying, as nearly as possible, the underlying value of a company and its cash flow.

Intrinsic value refers to some fundamental, objective value contained in an object, asset, or financial contract. If the market price is below that value it may be a good buy, and if above a good sale. There are several methods for arriving at a fair assessment of a share's intrinsic value like dividend discount model, residual income model and discounted cash flow (DCF) model. We have discussed in detail the DCF model below:

Discounted Cash Flow (DCF) Model
The discounted cash flow (DCF) model is a commonly used valuation method to determine a company's intrinsic value. The DCF model uses a company's free cash flow and the weighted average cost of capital (WACC). WACC accounts for the time value of money and then discounts all its future cash flow back to the present day. It is the expected rate of return that investors want to earn that's above the company's cost of capital.

Using DCF analysis, we can determine a fair value for a stock based on projected future cash flows. DCF analysis looks for free cash flows—that is, cash flow where net income is added with amortization/depreciation and subtracts changes in working capital and capital expenditures. The model also estimates the future revenue streams that might be received from a project or investment in a company. Ideally, the rate of return and intrinsic value should be above the company's cost of capital.

Why Intrinsic Value?
Analysts usually employ various methods to see if whether or not the intrinsic value of a security is higher or lower than its current market price, allowing them to categorize it as "overvalued" or "undervalued." Typically, when calculating a stock's intrinsic value, investors can determine an appropriate margin of safety, where the market price is below the estimated intrinsic value. By leaving a 'cushion' between the lower market price and the price one believes it's worth, one limits the amount of downside that would incur if the stock ends up being worth less than the estimate.

While calculating intrinsic value may not be a guaranteed way of mitigating all losses to the portfolio, it does provide a clearer indication of a company's financial health, which is vital when picking stocks intended to be held for the long-term. Moreover, picking stocks with market prices below their intrinsic value can also help in saving money when building a portfolio. Although a stock may be climbing in price in one period, if it appears overvalued, it may be best to wait until the market brings it down to below its intrinsic value to realize a bargain.

For a beginner getting to know the markets, intrinsic value is a vital concept to remember when researching firms and finding bargains that fit within his or her investment objectives. Though not a perfect indicator of the success of a company, applying models that focus on fundamentals provides a sobering perspective on the price of its shares.

Key Takeaways

• Intrinsic Value is the measure of the worth of an asset calculated by several methods
• A share's intrinsic value can be calculated using methods like dividend discount model, residual income model and discounted cash flow (DCF) model
• Intrinsic Value is important to determine if a security is "overvalued" or "undervalued" if compared to the market price
• It is also important to determine an appropriate margin of safety by keeping a cushion between the lowest market price and intrinsic value
• This helps limit the amount of downside that would incur if the stock ends up being worth less than the estimated intrinsic value
• Intrinsic Value helps provide a clearer indication of a company's financial health, which is vital when picking stocks intended to be held for the long-term

This material is part of an Investor Education and Awareness Initiative of Canara Robeco Mutual Fund