How to Calculate the Intrinsic Value of a Company
Warren Buffett famously said, “Price is what you pay. Value is what you get.”
Value is a core concept in value investing. The price of an investment may go up and down, depending on the market, but the value of the company always stays the same.
While there’s no simple formula, knowing a company’s intrinsic value helps you invest in high-quality companies at bargain prices. Let’s dive more into intrinsic value and how you can get started with two valuation models.
- Intrinsic value is what something is worth based on its intrinsic features.
- By comparing intrinsic value with a stock’s price, you can determine if a company is overvalued or undervalued.
- Price-to-earnings (P/E) multiple is a valuation method that helps you calculate intrinsic value through a five-year price target.
- The discounted cash flow (DCF) model estimates value based on expected future cash flows.
- Find stocks that cost much less than the intrinsic value of a company.
What is intrinsic value?
There are three types of value in the investing world:
- Relative value. What’s something worth in comparison to something else.
- Absolute value. What something is worth based on its intrinsic features.
- Perceived value. The value people assign to something in their mind.
Absolute value is also known as “intrinsic value.”
Value investors look at a company’s intrinsic value because stock prices reflect investors’ perception of reality, not necessarily reality itself. Value investors can take advantage of this.
Value investors buy when the stock price is lower than the intrinsic value of the company. Over the long-term, price will eventually equal absolute or intrinsic value, allowing the investor to sell and make a profit.
How to Calculate Intrinsic Value
There are several ways to calculate intrinsic value. We’re going to focus on two: the P/E Multiple Model and the DCF Model. Combine results from different methods to get a value range. Focus on conservative estimates.
1. P/E Multiple Model
Price-to-earnings or P/E multiple is a method that helps you calculate intrinsic value through a five-year price target. It’s a straightforward method that requires three inputs.
Let’s start with the formula for the P/E ratio:
- Intrinsic value = Earnings per share (EPS) x P/E ratio x (1 + r)^5
As you can see, the three inputs include earnings per share (EPS), the P/E ratio, and the expected earnings growth rate (r).
Say that you want to calculate the intrinsic value for Microsoft (MSFT). To find the EPS for Microsoft, head over to a website like Yahoo Finance or Morningstar. Type the ticker symbol into the search bar and look for the EPS under the financial data.
EPS shows you the company’s average earnings per share for four quarters. As of the time of writing, Microsoft had an EPS of 8.94.
Now find a reasonable P/E ratio for Microsoft. For this number, visit MorningStar. Insert the ticker symbol and click “Valuation” to find the company’s average five-year P/E ratio:
Microsoft has an average five-year Price/Earnings ratio of 36.59.
Finally, let’s find the expected growth rate. You can calculate this number on your own or visit Yahoo Finance and see what financial analysts have predicted. Click “Analysis” and scroll down to “Growth Estimates.” Look at the “Next 5 Years (per annum):”
Analysts predict that Microsoft will grow at a rate of 16.75% year-over-year over the next five years. But don’t stop here. Build in a margin of safety (just in case this estimation is inaccurate). A conservative margin of safety is 25%.
Apply this percentage to the 16.75% growth rate. 16.75 * (1 – 0.25) = 12.5625%
We can now put all these inputs together and calculate the five-year price target for Microsoft:
- Input 1 (EPS): 8.94
- Input 2 (P/E Ratio): 36.59
- Input 3 (Expected Growth Rate): 12.56%
Place these inputs in the formula: Earnings per share (EPS) x P/E ratio x (1 + r)^5. We recommend using a scientific calculator:
8.94 per share x 36.59 x (1 + 0.1256)^5 = $591.04 per share
This means that Microsoft’s intrinsic value will be $591.04 five years from now. But we need to calculate the intrinsic value today to compare with the current stock price. This means we need to discount the five year price target to get the Net Present Value.
Using a 9% discount rate (based on the historical return of the stock market), we’ll divide the original amount by 9%:
591.04 / (1 + 0.09)^5 = $388.04
Since Microsoft’s current stock price is $329.37, the company seems to be slightly undervalued. However, this is a rough estimate. Let’s take a look at another model to get a better idea if we should purchase Microsoft stock today.
2. Discounted Cash Flow Model
The discounted cash flow (DCF) model estimates value based on expected future cash flows. It determines the value of a company today by projecting how much money it will create in the future.
Free cash flow (FCF) is this calculation’s most important input. FCF is the amount of money a company can generate, even after expenses. The DCF model looks at the trailing twelve months FCF and projects it 10 years from now.
Let’s look at Microsoft again. According to Microsoft’s cash flow statement (under “Financials” on Yahoo Finance), the company’s trailing twelve months FCF is 60,420,000.
Also, take a look at Microsoft’s cash and cash equivalents. Check the company’s quarterly balance sheet for this information. At the time of writing, Microsoft had cash and cash equivalent value of $16,845,000:
Other inputs for this valuation model include:
- Total liabilities
- Growth rates
- Shares outstanding
Simply add the ticker symbol and the spreadsheet does the rest. Compared to Microsoft’s stock price of $329, notice how the first valuation model suggests that the company is undervalued while the second model suggests Microsoft is overvalued ($384 vs. $173).
Again, remember that these numbers are just estimates. In this case, we would need to dig more before determining if Microsoft is a safe buy right now. We could use other intrinsic value models like Return on Equity Valuation Model to compare with these results.
Remember: our goal is to find stocks that are much less than the company’s intrinsic value.
Why is intrinsic value important?
Intrinsic value is important because you can determine if a company is overvalued or undervalued by comparing it with the price of a stock.
Stock prices are known to everyone, but intrinsic value is always an estimate based on assumptions. It’s impossible to determine the exact value of a company because the value is based on projections of future growth and other assumptions.
You might be wondering, though. “If I can’t precisely calculate value, how do I protect myself from mistakes?”
Be conservative with your estimates!
Only buy stocks at a massive discount to intrinsic value. This practice gives you a margin of safety and allows you to make money even if your estimate is inaccurate. You might miss some opportunities, but conservatism is the best way to protect yourself from major losses.
In short, intrinsic value is an educated guess about a company. But an estimate is all you need. According to economist John Maynard Keynes, “It is better to be roughly right than precisely wrong.”
Calculate intrinsic value for your own companies
Both valuation methods can be used to calculate intrinsic value for most companies. But the reliability of your estimates will be higher for companies with stable earnings.
This is why it’s important to
- Stick with what you know.
- Avoid companies that are difficult to understand and hard to value (think banks or biotech companies).
- Never get too confident with the numbers – you must also rely on your common sense!
Too remember that intrinsic value is only part of the puzzle with value investing. A full fundamental analysis is needed to ensure that you become a successful value investor.
Did you enjoy this intro to value investing? Learn even more about this strategy when you sign up for the Value Investing Bootcamp: How to Invest Wisely on Udemy. This course helps you learn how to become a successful value investor, step-by-step. Check out the course here.