subject: Uncover Undervalued Stocks By Calculating Intrinsic Value [print this page] When calculating intrinsic value, you take into account the factors that contribute to the true value of an asset regardless of its current market value. This step is critical because you would not want to invest your hard-earned savings in an asset that at first seems to be a promising opportunity only to find out it is actually a money pit that will drain you of every last cent.
The more prudent investor will buy a stock or any other asset only if its prevailing market value falls below its intrinsic value. Although the intrinsic value is merely an approximate amount as opposed to an existing value, it is the computable figure that is closest to the true worth of an asset. In the event that an asset's intrinsic value has been fully realized, the investor will by then have made a profit on that asset. Even if cash flow is not always guaranteed, investing will not be as risky because of the resulting margin of safety--the percentage of the difference between an intrinsic value and a lower market value--that makes allowances for losses. As with the intrinsic value, the margin of safety is not an existing value but an approximate amount whose purpose is to guide investors in decision-making.
Calculating intrinsic value of a stock involves not one formula but three.
Get the projected end of duration earnings per share by multiplying the current EPS with the projected return on investment. Projected EPS = Current EPS x (Growth rate + 1) ^ Duration
Multiply the stock's average price-earnings ratio with the projected EPS to get the forecasted stock price or future value.Divide the future value by the projected ROI to get the intrinsic value or net present value.Calculating seems simple but it will still involve some forethought because no one knows exactly what the future will bring. To see how the intrinsic value computation is applied, consider the following example:
You wish to invest in ABC stock whose current price is at $30.00 and whose average PE ratio is at 15. You hope to generate a significant return after 10 years. If the stock's EPS is at $2.50 and you've estimated the EPS growth rate at 10 percent (0.10) for every year over the next 10 years, the EPS after the tenth year would be $6.48. Multiply this amount by the average PE ratio and you get a future value of $97.26. Divide the future value by the projected 10-year ROI of 2.59 (i.e., (0.10 growth rate + 1) ^ 10 years) and you get an intrinsic value of $37.49. The intrinsic value of the stock is higher than the current market value of $30.00 which makes it a viable asset, but unless the difference between the two values falls within your preferred margin of safety, it might be wise to disregard ABC stock and instead look for other investment outlets. The margin of safety for ABC stock is roughly 20 percent. Although the acceptable margin of safety varies between investors, the more sensible ones place it at 50 percent or greater.
Calculating intrinsic value is simply an application of a scientific approach in determining whether or not to buy specific assets. Although it still relies heavily on probability as there is no absolute guarantee of profit, it enables investors to weigh the risks involved as accurately as possible.
