Notice how a piping hot bowl of Maggi noodles tastes extra nice – even if it’s whipped up at a roadside stall – in a cold place? It’s the very same pack that you eat in your concrete jungle, wherever you are. But somehow, in the Kodaikanal hills or the Rishikesh mountains, it is unbelievably comforting and delicious.
It is the very same noodles; you just happen to value it more in a cold place. Some people may not even enjoy Maggi in their city of work or residence, but still gorge on it in cold places.
In the same way, a company’s real, true or intrinsic value versus its market value might be different from one another even though it is the same company. And value investors tend to only invest when the company’s market value is lower than its intrinsic value. They see it as the stock trading at a discount.
Let’s understand how market value and intrinsic value work and how they are different from one another.
This is very easy to ascertain and is therefore a good place to start. The market value of a company is reflected by it’s stock price. Also known as market capitalization, it is calculated by multiplying the current stock price by the number of outstanding shares that are trading in the market. As the stock price fluctuates, so does the market value of the company. Therefore, it can be said with certainty that the stock price is a good indicator of how the general public feels about a certain stock or the market value of the stock.
There is a possibility that investors may be willing to pay a certain premium or may be discounting some potential factors that may influence the growth of the company in the future. Therefore, they ascribe a certain market value to it, but that may not be the inherent value of the stock.
A little complex procedure of what is known as fundamental analysis, is used to identify the intrinsic value of a company. Fundamental analysis involves a thorough examination of the company financials, the state of the market in context of the company in question, the company’s sector of operation and the company’s business plans. When we peel away the layers of market influence, what lies underneath is the intrinsic value of the company or the stock.
Intrinsic value vs market value
If a stock has an intrinsic value that is higher than its market value, it is seen as “undervalued” and therefore favoured by value investors.
Conversely, if a stock has an intrinsic value that is lower than its market value, it is seen as “overvalued” and therefore viewed less favourably by value investors.
The market value can be swayed by demand and supply, which is in turn impacted by the public’s general sentiment on a given day and sentiment towards a particular company. For example, you might have noticed in the past that some budget announcements that the public viewed unfavourably also resulted in falling stock prices. But think about it – the news alone does not immediately affect any company’s earnings or sector profitability (let alone the whole market’s profitability). It does not actually mean that all the companies in the market will deliver lower returns. This price decrease comes from people panicking and selling stock in a knee jerk reaction. Stocks are now undervalued. At some point, everyone gathers their wits, and then there is an upward price correction.
Alternatively, some news that is viewed favourably might just result in the stock price rising rapidly. For example, imagine that ABC Construction announces a new hotel development in X location and around the same time there is an announcement that some caves in X might get added to the UNESCO list of heritage sites or that location X might get a new airport. It’s quite possible that the stock price of ABC Construction will rise because of demand. But this news alone does not reflect any actual, hard numbers increase in profitability that can offer tangible ROI to the investor, does it? The stock of ABC Construction is now overvalued. There may be room for the price to adjust downwards at some point.
How to use intrinsic value
Once you have both the intrinsic value and the market value of a company, assuming you are going with the value investing strategy, you will typically be advised to look for stocks that are undervalued, or that are trading at a discount.
Let’s say that Stock P is trading at Rs 52 while stock Q is trading at Rs 48. At first glance, it seems like stock Q is the cheaper option, does it not? But what if, according to your intrinsic value calculations, the worth of Stock P is actually around Rs 55 while the price for Stock Q should be around Rs 45. Well, aren’t you better off buying stock P? The price of stock Q is likely to correct downward (which corresponds to a potential loss for the investor) whereas the price of stock P will correct upward (which corresponds to a potential profit for the investor).
Why do some investors ignore intrinsic value?
You might notice that very short term traders, especially day traders have a preference for technical analysis over fundamental analysis. Technical analysis is the study of patterns in the stock price (so basically, it deals with market value). Now, when an investor buys and sells stock within minutes and hours, he is only concerned with short-term volatility and not with the long-term worth of the company. Theirs is an expert’s game and the stakes are often high.
Various methods of calculation to identify intrinsic value
Fundamental analysis most commonly use PE ratio – that is price to earnings ratio – to arrive at the intrinsic value of a stock, but they may also use PEG ratio (which is price to earnings growth ratio) or a price to book value ratio or a price to sales ratio.
Some investors use what is called a discounted cash flow model and others use a dividend Discount model. These are all considered to be efficient methods of valuation.
Read our blog post “What is valuation and how to pick stocks” to understand how to go about it.
Intrinsic value is an amazing tool for risk management and stock selection, one that is advocated strongly by investor par excellence, Warren Buffett. Investors could consider the intrinsic value of stocks to enable making an informed choice when it comes to adding stocks to the investment portfolio. Understand and use it to enter a stock investment at an opportune moment.