With how much attention the stock market is getting now, it is no wonder that some stocks end up undervalued and overvalued. It’s important to identify the objective price of stocks to make profitable trades. This article will delve into how to calculate the intrinsic value of stocks.

What is a stock’s intrinsic value?

A stock’s intrinsic value is the perceived or calculated true value of a company’s stock, based on fundamental analysis. It represents what a stock is actually worth, as opposed to its current market price, which can be influenced by market conditions, investor sentiment, and other factors.

Investors use objective value to identify whether a stock is overvalued or undervalued. If the objective value is higher than the current market price, the stock may be considered undervalued and a potential buy. Conversely, if the objective value is lower than the market price, the stock might be overvalued and a candidate for selling.

What factors determine the intrinsic value of a stock?

• Earnings and revenue. The company’s current and projected earnings are central to objective stock value calculations. Higher earnings typically lead to a higher objective value.
• Growth prospects. The expected rate at which the company’s earnings or revenues will grow in the future is crucial. Companies with high growth potential generally have higher intrinsic values.
• Assets and liabilities. The company’s balance sheet, including assets, liabilities, and shareholder equity, also contributes to determining intrinsic value.
• Risk factors. The level of risk associated with the company, including industry risks, competition, and macroeconomic conditions, can affect its objective value. Higher risks typically reduce objective value.

How to calculate the intrinsic value of a stock

The most common method for calculating intrinsic stock value is the discounted cash flow (DCF) analysis. Here’s a step-by-step guide:

Step 1. Gather financial data

You’ll need the following financial data for the company:

• Free cash flow (FCF). This is the cash generated by the company that is available to be distributed to investors. You can find this in the company’s financial statements.
• Growth rate. Estimate the growth rate of the company’s FCF. This can be based on historical growth rates, industry averages, or analyst projections.
• Discount rate (weighted average cost of capital – WACC). This rate represents the company’s cost of capital, including debt and equity. It accounts for the time value of money and risk. WACC is often used as the discount rate.
• Terminal growth rate. This is the rate at which you expect the company’s FCF to grow indefinitely after the forecast period. It’s typically lower than the historical growth rate.

Step 2. Project future free cash flows

Estimate the company’s FCF for the next 5-10 years. This involves applying your growth rate to the current FCF. For example, if the current FCF is \$100 million and you expect it to grow at 5% annually, the FCF for the next year would be \$105 million, and so on.

Step 3. Calculate the terminal value

After the forecast period, calculate the terminal value, which represents the value of all future cash flows beyond the forecast period. Formula:

Step 4. Discount the cash flows to present value

Discount the projected FCFs and the terminal value back to their present value using the WACC. Formula:

Do this for each year’s FCF and for the terminal value.

Step 5. Sum the present values

Add up all the present values of the FCFs and the terminal value. This sum is the intrinsic value of the entire company.

Step 6. Determine the intrinsic value per share

Divide the total intrinsic value by the number of outstanding shares to get the intrinsic value per share. Formula:

Step 7. Compare with the current market price

Compare the intrinsic value per share with the current market price. If the intrinsic value is higher than the market price, the stock might be undervalued. If it’s lower, the stock might be overvalued.

This process gives you a theoretically grounded estimate of what the stock is truly worth based on its expected future performance.