<\/span><\/h3>\n\n\n\nFinancial metrics can also be used to determine the intrinsic value of a stock. The Earnings per Share (EPS) and the Price-Earnings Ratio (PE ratio) are used in a formula to calculate the intrinsic value. The formula is as follows:<\/p>\n\n\n\n
Intrinsic value = EPS * (1+r) * PE ratio<\/strong><\/p>\n\n\n\nHere, \u2018r\u2019 is the expected rate of interest from the security.<\/p>\n\n\n\n
You can use any of these formulas based on the information you can access. To get information about a company\u2019s PE ratio and Earnings Per Share, check out Tickertape\u2019s Stock Pages. They are equipped with every information you need to analyse a company. Explore them now!\u00a0<\/p>\n\n\n\n
<\/span>4. Relative valuation method<\/strong><\/span><\/h3>\n\n\n\nThis method compares the stock price with the company\u2019s fundamentals, such as revenue, net income, profits, and the book value of equity shares. When you buy a stock, it makes you a part-owner of the company issuing it. As a result, you also own a portion of these key fundamentals.<\/p>\n\n\n\n
The relative valuation method of deriving the intrinsic value of a stock involves comparing the company\u2019s fundamentals, such as the PE ratio and book value of equity shares, with that of their peers.<\/p>\n\n\n\n
One of the key ratios you can use for relative value analysis is the PE ratio. So if the stock price is Rs. 100 and the company\u2019s earnings per share is Rs. 10, the PE ratio will be Rs. 10. This means that you pay Rs. 10 for each rupee of the company\u2019s earnings. To see if this price is fair, compare it with the PE ratio of the company\u2019s peers. If the company\u2019s PE ratio is lower than the average PE of its competitors, you get the stock for a cheaper price and vice versa.<\/p>\n\n\n\n
<\/span>Shortcomings of the relative valuation method<\/strong><\/span><\/h4>\n\n\n\nIn this method, you consider the company\u2019s fundamentals as of today. However, these figures are subject to change with important developments within the company and the economy. This will certainly have a significant impact on the value of the stock.<\/p>\n\n\n\n
<\/span>Intrinsic value formula<\/strong><\/span><\/h2>\n\n\n\nHere\u2019s a brief of the different types of formulas used to calculate the intrinsic value.<\/p>\n\n\n\n
<\/span>DCF method<\/strong><\/span><\/h4>\n\n\n\nIntrinsic value = CF1\/(1+r)1 + CF2\/(1+r)2 + . . . + TV\/(1+r) n<\/strong><\/p>\n\n\n\nHere, <\/p>\n\n\n\n
\nCF = Expected cash flow for a specific period (e.g., CF1 = cash flow year one)<\/li>\n\n\n\n r = Discount rate<\/li>\n\n\n\n TV = Terminal value (estimated cash flow after the projection period)<\/li>\n\n\n\n n = Specific period (e.g., years, quarters, months, etc.)<\/li>\n<\/ul>\n\n\n\n<\/span>Dividend Discount model<\/span><\/h4>\n\n\n\nIntrinsic value = [EDPS\/(r-g)] + Present value of the expected selling price of the stock\u00a0<\/strong><\/p>\n\n\n\nHere, <\/p>\n\n\n\n
\nEDPS = Expected Dividend Per Share<\/li>\n\n\n\n r = The cost of equity capital<\/li>\n\n\n\n g = The dividend growth rate<\/li>\n<\/ul>\n\n\n\n<\/span>The financial metric formula for intrinsic value<\/span><\/h4>\n\n\n\nIntrinsic value = EPS * (1+r) * P\/E ratio<\/strong><\/p>\n\n\n\nIn the ratio, \u2018r\u2019 is the expected rate of interest from the security.<\/p>\n\n\n\n
<\/span>Risk adjusting the intrinsic value<\/strong><\/span><\/h2>\n\n\n\nThe risk adjusting of intrinsic value does not solely depend on a formula. <\/p>\n\n\n\n
Let’s look at the two commonly used risk-adjusting methods in calculating a share’s intrinsic value.<\/p>\n\n\n\n
\nPresent value method<\/strong><\/li>\n<\/ol>\n\n\n\nThe present value method is widely used to determine the intrinsic value of a stock. This method assesses the present value of the expected cash flows from owning the stock, taking into account the time value of money. The basic idea behind this method is that the value of a rupee received in the future is worth less than the rupee received today. <\/p>\n\n\n\n
To calculate the present value, you need to first estimate the expected cash flows from the stock, including dividends and other gains. Then using a discount rate (calculated based on several factors), the future value of cash flows is reduced to the present value. The resultant figure is the maximum price that an investor would be willing to pay for the stock. <\/p>\n\n\n\n
By comparing the value to the current stock price, you can determine if the stock is undervalued or overvalued. If the present value is higher than the current price, it may indicate that the stock is undervalued and vice versa. <\/p>\n\n\n\n
\nRelative value method<\/strong><\/li>\n<\/ol>\n\n\n\nSeveral investors use the relative method to calculate the intrinsic value of the shares. Here, you need to compare the stock price with the company’s expected value. For this, you may analyse a company’s fundamental values from its financial statements, revenues, profits, etc. <\/p>\n\n\n\n
When you invest in a company or buy stocks, you get a percentage of these fundamentals. You try to maximise profits by getting a share of these fundamentals at the lowest price possible. Hence, you can use the PE ratio and the earnings per share to understand how much you are paying for a rupee of return.<\/p>\n\n\n\n
The relative value approach to calculate the intrinsic value is:<\/p>\n\n\n\n
Intrinsic value<\/strong> = Price to earnings ratio * Earnings per share<\/strong><\/p>\n\n\n\n<\/span>Why is intrinsic value not preferred in technical analysis?<\/strong><\/span><\/h2>\n\n\n\nWhile intrinsic value is a great way to understand the true value of the shares, it is not used during technical analysis. Some of the reasons for the same are:<\/p>\n\n\n\n
\nIntrinsic value is considered unstable as it is based on the value of the company’s fundamentals, like sales, profits, etc. These values are highly dynamic and are usually different every financial year.<\/li>\n\n\n\n Intrinsic value estimation is only limited to shares. You cannot use it to predict the true value of assets like commodities, currencies, etc. <\/li>\n\n\n\n Also, the intrinsic value of shares can sometimes mislead you as the market value may never reach the estimated intrinsic value. <\/li>\n<\/ul>\n\n\n\n<\/span>The <\/strong>intrinsic value of call option<\/strong><\/span><\/h2>\n\n\n\nA call option’s intrinsic value shows the value by which the strike price of an option will yield profits. You can calculate the intrinsic value of the call option using the following formula:<\/p>\n\n\n\n
Intrinsic value<\/strong> of a call option = Underlying current price of the stock \u2013 Call strike price<\/strong><\/p>\n\n\n\nThe formula helps understand the advantage of exercising an option immediately.<\/p>\n\n\n\n
<\/span>The intrinsic value of the put option<\/strong><\/span><\/h2>\n\n\n\nThe put option’s value increases when the stock price is lower than the strike price. You can calculate the intrinsic value of the put option using the following formula:<\/p>\n\n\n\n
The intrinsic value of a put option = Put strike price \u2013 Underlying current price of the stock<\/strong><\/p>\n\n\n\n<\/span>Intrinsic value Vs market price<\/strong><\/span><\/h2>\n\n\n\n
The intrinsic value of a share is quite different from its market value. The intrinsic value depicts the worth of the stock as measured by its return-generating potential. This is determined using fundamental analysis of stock and statistical calculations. Meanwhile, the market value is what the investors are paying for the stock. It is determined by the demand and supply of the stock.<\/p>\n\n\n\n
The market value and intrinsic value of a stock are not usually the same. The difference is what helps investors make the right trading decisions. Here\u2019s how:<\/p>\n\n\n\n
<\/span>If the intrinsic value is higher than the market value<\/strong><\/span><\/h4>\n\n\n\nIf the intrinsic value is higher than the current market value of a stock, it means that the stock is undervalued. Though the stock has good potential, investors have not yet noticed it. For potential investors, this is a sign to buy such stocks. If you invest in such undervalued stocks, you will stand to gain when the price of the stocks rises in future as their inherent worth is recognised.<\/p>\n\n\n\n
<\/span>If the intrinsic value is lower than the market value<\/strong>