How to Calculate Intrinsic Value: The Most Comprehensive Guide! (Updated 2024)

What is Intrinsic Value?

Let's talk about why finding the actual value of a company is SO important! It's like unlocking a secret code to the potential success of your investment.

Picture this: You're thinking of investing your hard-earned money in a company. But, how do you know if the price you're paying for its shares is worth it? This is where intrinsic value comes in.

So what does intrinsic value mean?

This is the true value of a business, which may be higher or lower than the current market price.

It represents how much the business is really worth, beyond just its current selling price.

Now, as a savvy investor, you know that it's crucial to estimate this value so you can make smart decisions about buying and selling stocks.

By doing regular stock valuations, you'll get a much better sense of the companies you're looking to invest in, and whether they're currently over- or undervalued.

And here's the exciting part...

Knowing whether a company is undervalued or overvalued means you can really take advantage of the "buy low, sell high" approach that makes value investing so profitable.

So don't be a "fake investor" - get to know the intrinsic value of your stocks and make some serious profits!

Intrinsic Value Definition

Intrinsic value refers to the inherent worth or value of something, regardless of its market or exchange value.

It is the actual value of an asset or investment, based on its characteristics and qualities, rather than its perceived value in the market.

Intrinsic value can be applied to various types of assets, such as stocks, real estate, commodities, and even currencies.

For example, the intrinsic value of a stock is determined by factors such as the company's actual financial performance, growth prospects, and management quality, among others.

Similarly, the intrinsic value of a piece of real estate is determined by its location, size, condition, and potential for income generation. The intrinsic value of gold is determined by its rarity, durability, and unique properties.

In the finance world, you can use intrinsic value to figure out how much a company or asset is truly worth.

You need to look at a bunch of different factors, like how much money the company is making (revenue), how much profit it's earning (earnings), how much cash it has on hand (cash flow), and how many assets it owns (assets).

You also need to take into account the potential for growth, debt-repayment capacity, and profitability in the future to ballpark the fair value of that company.

So why is all of this important?

When you calculate intrinsic value, you can tell whether a company is undervalued (meaning it's worth more than the market thinks) or overvalued (meaning it's worth less than the market thinks).

This information is super helpful if you're thinking about investing in a company or asset – you can use it to make smarter decisions and get the most bang for your buck.

Ethics vs Philosophy

Intrinsic value is also an important concept in ethics and philosophy because it helps you understand what things are valuable in and of themselves, rather than just as a means to an end.

Therefore, intrinsic value ethics is the study of what things are intrinsically valuable and how we should act to promote and protect those values.

This can include things like the value of human life, the value of nature, and the value of art.

In contrast, intrinsic value philosophy takes a broader approach to the concept of intrinsic value.

It looks at the value of things beyond just living beings and considers the value of ideas, concepts, and principles.

For example, in philosophy, you might ask questions like "What is the meaning of life?" or "What is the nature of reality?" that go beyond the scope of intrinsic value ethics.

Intrinsic vs Extrinsic Value

Have you ever thought about what makes something valuable? Have you ever heard of anything that has intrinsic and extrinsic value?

When it comes to value investing, there are two main ways of assessing the worth of a company or asset: extrinsic and intrinsic value.

Intrinsic value refers to the actual value of a company or asset based on its inherent characteristics, such as its cash flow, earnings, liabilities, and assets.

Extrinsic value, on the other hand, refers to the value placed on a company or asset by external factors, such as market demand, hype, or the opinions of other investors.

For example, a company may have a high market value simply because it's currently in vogue with investors, or because of a media buzz surrounding a particular product or service.

While extrinsic value can play a role in short-term market fluctuations, it's ultimately the intrinsic value of a company or asset that determines its long-term potential.

So, next time you're considering an investment opportunity, make sure that you'll take a closer look at the intrinsic value and assess the true worth of that investment before making a decision.

Intrinsic vs Instrumental Value

Instrumental value refers to the usefulness or practicality (ability to generate returns for investors) of an asset or investment. This means that an asset may have instrumental value even if its intrinsic value is low.

This value is often influenced by external factors like market sentiment and investor behavior, which can cause prices to rise or fall regardless of the asset's intrinsic value.

For example, a dividend-paying stock may have high instrumental value because investors believe it will generate high returns, even if its intrinsic value is not strong.

Similarly, a piece of real estate may have a low intrinsic value due to its location or condition, but it may have high instrumental value if it can be easily rented out for a steady stream of income.

While instrumental value is important, it's not the focus of value investing.

Value investors are primarily concerned with intrinsic value, which is the foundation of their investment philosophy.

Intrinsic Value vs Market Value

It's important to note that intrinsic value is not the same as market value.

Market value can go up and down depending on a whole bunch of things like economic conditions, political events, and even what people are thinking and feeling. It can be pretty unpredictable!

In contrast, intrinsic value is based on the fundamental qualities of an asset, like its quality, rarity, and usefulness.

This means that intrinsic value can be a more reliable way to measure the long-term worth of an investment.

That way, you can make a more informed decision about whether it's a good investment for you.

For example, if you have a vintage guitar that was played by a famous musician, its current market value might go up and down depending on how people feel about that musician.

But its intrinsic value, the fact that it's a rare, unique piece of musical history, is always going to be there, no matter what's happening in the market.

So if you're thinking about investing in something, it's always a good idea to take a look at its intrinsic value and consider that alongside the market value.

Now that you understand the definition of intrinsic value, let's find out how to calculate it. 

How Does Warren Buffett Calculate Intrinsic Value?

Did you know that Warren Buffett is considered one of the most successful investors in history? One of the reasons for his success is that he's great at figuring out how much a company is really worth.

So, how does he do it?

Although Buffett hasn't revealed his exact formula, he has provided some insight into his thought process, and he emphasizes the importance of analyzing a company's financial statements as well as its qualitative aspects.

Well, instead of relying on a specific formula, Buffett takes a comprehensive fundamental analysis approach by analyzing a range of factors.

He looks at the financial and operational performance of a company, its potential for future growth and profitability, and the quality of its management team, among other things.

For example, he likes to look at how well the company has been doing financially and how it might do in the future. He's interested in companies that have been making a lot of money compared to how much they've invested.

He also pays attention to things like how good the company's management is, and whether the company has a strong position in the market.

Besides quantitative factors, Warren Buffett also takes into account qualitative aspects such as a company's brand name, loyal customer base, and competitive moat which makes it difficult for competitors to enter the market.

At the end of the day, Buffett believes that focusing on intrinsic value is the key to successful long-term investing, and his track record certainly speaks for itself.

How to Calculate Intrinsic Value of a Stock

Understanding the intrinsic value of stocks is an essential part of making informed investment decisions.

Intrinsic value calculation is the process of determining the underlying value of a stock based on its current financial performance and potential for future growth.

You can start by gathering information about the company. Look at its financial statements, including income statements, balance sheets, and cash flow statements.

You'll also need to determine the discount rate, which is the rate of return you could get from a different investment of similar risk. Once you have this information, you can start calculating intrinsic value.

There are several financial models you can use, including discounted cash flow analysis, price-to-earnings ratio, and dividend discount model.

The discounted cash flow analysis method involves projecting future cash flows and discounting them to their present value, while the price-to-earnings ratio method involves comparing the company's stock price to its earnings per share.

The dividend discount model calculates a stock's intrinsic value based on the future dividends the company is expected to pay.

It's important to note that finding intrinsic value is not an exact science, and there are a lot of factors that can influence the final value.

In this article, I'll walk you through my foolproof method for estimating intrinsic value – the discounted free cash flow model.

So, what exactly is the discounted free cash flow model?

It's a valuation method that estimates the intrinsic value of a company by discounting its expected future cash flows back to their present values.

This means that the model takes into account the expected growth of the company, the cash it generates, and the cost of capital, among other factors.

By doing this, you can get a more accurate estimate of what the company is worth, regardless of its current stock price.

Now, let's take a look at the 6-step process below.

Step 2: Calculate Discount Rate (WACC)

In my opinion, the discount rate is the most crucial component of our discounted cash flow analysis (DCF valuation method) .

If you frequently perform stock valuation, you would realize that we cannot use the same discount rate for every single stock.

The key mistake that many investors make is that they use a random discount rate, says 5%, 6%, or 7%, to compute the discounted cash flows of their stock.

After several years of being an independent investor, my experience tells me that every single stock will come up with a different discount rate.

Here are some real-world examples (I selected a number of random stocks):