Calculating the intrinsic value of a company

The intrinsic value of an asset is a measure of how much the asset is really worth. It is the present value of all the expected future cash flows, discounted at an appropriate discounting rate. Intrinsic value is distinct from the market value of the asset.

Intrinsic value is the real value of the asset whereas, market value is often the value the market assigns to a particular class of asset. However, comparing it to the current price can give investors an idea of whether the asset is undervalued or overvalued. Financial Analysts use cash flows to calculate the intrinsic value or the underlying value of a company or a stock

Analysts often calculate the intrinsic value of a particular class of asset to compare it with the market value of the same class of asset to gain valuable insights and make financial decisions. Generally, if the intrinsic value of an asset is more than the market value then the asset is said to be undervalued and considered investable. In the same way, if the intrinsic value is lesser than the market value of an asset then it is said to be overvalued and considered overvalued. This is because, the market value of an asset is affected by a large number of factors outside the control of a company which might be internal or external to it – business cycles, market sentiments, investor’s risk appetite, etc. However, in the long run, it is considered that the market value will eventually reflect the intrinsic value of the asset.

Thus, as a general principle,

• Intrinsic Value > Market Value → Asset is undervalued, thus investible

• Intrinsic Value < Market Value → Asset is overvalued, thus not investible

• Intrinsic Value = Market Value → Indifferent

Calculating the Intrinsic Value of a Company using the Discounting Cash Flow Model –

Where,

• Cash Flow (CFn, n = year) is the expected cash flow for the year e.g. CF1 = Cash Flow for 1st year

• Discounting Rate (r) is a rate used to discount the future value to its present value, often the cost of a particular source of finance

• Terminal Value (TV) is the estimated value at the end of projection year n
  

Calculating intrinsic value is an objective process, different analysts may use different models or parameters to arrive at their estimates. Some of the models used to arrive at the intrinsic value are as under -

1. Asset Based Valuation

2. EBITDA Multiple

3. Dividend Discount Model
   

4. Discounted Cash Flow (as shown above)

[Originally published on 9th June, 2024]