Investing in stocks can be both exciting and intimidating. Understanding a stock’s intrinsic value, or the true value of a company’s assets, allows you to make informed investment decisions. In this article, we will discuss the concept of intrinsic value and how to calculate it for a stock.

What is Intrinsic Value?

Intrinsic value is an estimate of the actual worth of a company based on its fundamental financial characteristics, rather than its current market price. It is used by investors to determine if a stock is undervalued or overvalued, which can help them make better investment decisions.

Calculating the Intrinsic Value

Two popular methods to calculate intrinsic value are Discounted Cash Flow (DCF) and Dividend Discount Model (DDM). We’ll discuss both methods in this article.

1. Discounted Cash Flow (DCF)

The DCF method involves projecting a company’s future cash flows and discounting them back to their present values using a discount rate. Following these steps will guide you through the process:

Step 1: Estimate future cash flows

Forecast the company’s free cash flow for the next several years using financial statements and growth assumptions.

Step 2: Determine the terminal value

Estimate the company’s cash flow beyond your forecast period by assuming a perpetual growth
rate, which represents stable long-term growth.

Step 3: Calculate the present value

Discount your estimated cash flows back to their present values using an appropriate discount rate that reflects the riskiness of the investment.

Step 4: Calculate intrinsic value per share

Divide your total present value calculation by the number of shares outstanding to determine intrinsic value per share.

2. Dividend Discount Model (DDM)

The DDM method focuses on predicting dividends a company will pay over time and discounts them back to their present values using a required rate of return. Here’s how you can calculate intrinsic value using DDM:

Step 1: Estimate future dividends Forecast the expected dividends per share the company will pay over a certain period, typically a few years, based on historical data and growth assumptions.

Step 2: Calculate the present value Discount these future dividend payments back to their present values using your required rate of return.

Step 3: Determine the stock’s intrinsic value Sum up present values of all future dividend payments to get the intrinsic value of the stock.

Conclusion

Calculating the intrinsic value of a stock is fundamental for making informed investment decisions. By evaluating a company’s financial health and comparing its intrinsic value to market price, you can determine if a stock is undervalued or overvalued. Keep in mind that these calculations involve assumptions and estimates that can influence the final result. Always consider other factors in your investment decision-making process and consult with a financial advisor if necessary.