How to Calculate the Intrinsic Value of a Stock

What is a stock worth? You could simply go with the current stock price. But that price is subject to the market's whims. Another alternative is to determine the stock's intrinsic value. The intrinsic value of a stock is its true value. It refers to what a stock (or any asset, for that matter) is actually worth -- even if some investors think it's worth a lot more or less than that amount.

Three of the most popular approaches.

i. Discounted cash flow analysis

Some economists think that discounted cash flow (DCF) analysis is the best way to calculate the intrinsic value of a stock. To perform a DCF analysis, you'll need to follow three steps:

1. Estimate all of a company's future cash flows.

2. Calculate the present value of each of these future cash flows.

3. Sum up the present values to obtain the intrinsic value of the stock.

Estimating a company's future cash flows requires you to combine the skills of Warren Buffett and Nostradamus. You'll probably need to delve into the financial statements of the business (unsurprisingly, previous cash flow statements would be a good place to start). You'll also need to gain a decent understanding of the company's growth prospects to make educated guesses about how cash flows could change in the future.

Intrinsic value = (CF1)/(1 + r)^1 + (CF2)/(1 + r)^2 + (CF3)/(1 + r)^3 + ... + (CFn)/(1 + r)^n

where:

· CF1 is cash flow in year 1, CF2 is cash flow in year 2, etc.

· r is the rate of return you could get by investing money elsewhere

Let's say you want to perform a discounted cash flow analysis for the stock of XYZ. You look at its current cash flow statement and see that it generated cash flow of K100million over the last 12 months. Based on the company's growth prospects, you estimate that XYZ's cash flow will grow by 5% annually. If you use a rate of return of 4%, the intrinsic value of XYZ would be a little over K2.8 billion using discounted cash flows going out for 25 years.

ii. Analysis based on a financial metric

Intrinsic value = Earnings per share (EPS) x (1 + r) x P/E ratio

Let's say that XYZ generated earnings per share of K3.30 over the last 12 months. Assume that the company will be able to grow its earnings by around 12.5% over the next five years. Finally, let's suppose the stock currently has a P/E multiple of 35.5. Using these figures, XYZ's intrinsic value is:

(K3.30 per share) x (1 + 0.125) x 35.5 = K131.79 per share

iii. Asset-based valuation

Intrinsic value = (Sum of a company's assets, both tangible and intangible) – (Sum of a company's liabilities)

What is XYZ's intrinsic value using this approach? Let's assume the company's assets totaled K500million. Its liabilities totaled K200million. Subtracting the liabilities from the assets would give an intrinsic value of K300million for the stock.

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