What is an Intrinsic Value Formula?
The formula for Intrinsic value represents the net present value of all the future free cash flows to equity (FCFE)Future Free Cash Flows To Equity (FCFE)FCFE (Free Cash Flow to Equity) determines the remaining cash with the company's investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company's equity capital management of a company during the entire course. It reflects the actual worth of the business underlying the stock, i.e., the amount of money that can receive if the whole business and all of its assets are sold off today.
Table of contents
- What is an Intrinsic Value Formula?
- Intrinsic value formula calculates a company’s worth by determining the present value of its future free cash flows to equity. It reflects the business’s true worth and potential profit if all assets were sold at current market value.
- To find a stock’s intrinsic value, divide the total business value by the number of outstanding shares. Compare this to the market price to see if it’s overvalued, undervalued, or priced correctly.
- Value investors buy undervalued stocks with solid fundamentals, expecting the market to eventually correct and raise the stock price back to its fair value.
Intrinsic Value Formula
The intrinsic value formula for business and stock is represented as follows –
#1 – Intrinsic Value Formula of a Business
Mathematically, the intrinsic value formula of a business can be represented as,
- where FCFEi = Free cash flow to equity in the ith year
- FCFEi = Net income i + Depreciation & Amortisation i – Increase in Working Capital i – Increase in Capital Expenditure i – Debt Repayment on existing debt i + Fresh Debt raised i
- r = Discount rate
- n = Last projected year
#2 – Intrinsic Value Formula of a Stock
The calculation of the intrinsic value formula of the stock is done by dividing the value of the business by the number of outstanding shares of the companyOutstanding Shares Of The CompanyOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet. in the market. The value of stock derived in this way is then compared with the market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price. to check if the stock is trading above / at par / below its intrinsic value
Intrinsic Value Formula Stock = Intrinsic Value Business / No. of outstanding shares
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Explanation of the Intrinsic Value Formula
The calculation of the formula of the intrinsic value of a stock can be done by using the following steps:
- Firstly, determine the future FCFE for all the projected years based on the available financial plan. The projected FCFEs can be computed by taking the latest FCFE and multiply it with the expected growth rate.
- Now, the discount rate is determined based on the current market return from an investment with a similar risk profile. The discount rate is denoted by r.
- Now, calculate the PV of all the FCF by discounting them using the discount rate.
- Now, add up the PV of all the FCF calculated in step 3.
- Next, the terminal value is computed by multiplying the FCFE of the last projected year by a factor in the range of 10 to 20 (required rate of return). The terminal value represents the value of the business beyond the projected period until the business is shut down.
Terminal value = FCFE n * Factor
- To arrive at the value for the entire business, add up the value of step 4 and the discounted value of step 5 along with any cash cash equivalents (if available).
- Finally, the intrinsic value per share can be derived by dividing the value in step 6 by the number of shares outstanding of the company.
Example of Intrinsic Value Formula (with Excel Template)
Let us take an example of a company XYZ Limited which is currently trading in the stock market at $40 per share with 60 million shares outstanding. An analyst intends to predict the stock’s intrinsic value based on the available market information. The prevailing required rate of return expected by the investors in the market is 5%. On the other hand, the company’s free cash flow is expected to grow at 8%.
The following financial estimates are available for CY19 based on which the projections have to be made:
|All Amount in Millions||CY19 (E)|
|Net Profit After Tax||$200.00|
|Depreciation & Amortisation||$15.00|
|Increase in Working Capital||$20.00|
|Debt Repayment on Existing Debt||$50.00|
|Fresh Debt Raised||$100.00|
|Required Rate of Return||5.00%|
|FCFE Growth Rate||8.00%|
So, from the above-given data, we will first calculate the FCFE for CY19.
FCFE CY19 (in millions) = Net income + Depreciation & Amortisation – Increase in Working Capital – Increase in Capital Expenditure – Debt Repayment on existing debt + Fresh Debt raised
- FCFE CY19 (in millions) = $200.00 + $15.00 – $20.00 – $150.00 – $50.00 + $100.00
- = $95.00
Now, using this FCFE of CY19 and FCFE growth rate we will calculate the Projected FCFE for CY20 TO CY23.
Projected FCFE of CY20
- Projected FCFE CY20 = $95.00 Mn * (1 + 8%) = $102.60 Mn
Projected FCFE of CY21
- Projected FCFE CY21 = $95.00 Mn * (1 + 8%)2 = $110.81 Mn
Projected FCFE of CY22
- Projected FCFE CY22 = $95.00 Mn * (1 + 8%)3 = $119.67 Mn
Projected FCFE of CY23
- Projected FCFE CY23 = $95.00 Mn * (1 + 8%)4 = $129.25 Mn
Now we will calculate the Terminal ValueCalculate The Terminal ValueThe terminal value formula helps in estimating the value of a business beyond the explicit forecast period. It includes the value of all cash flows, regardless of duration, and is an important component of the discounted cash flow model (DCF)..
- Terminal valueTerminal ValueTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. = FCFE CY23 * (1 / Required rate of return)
- = $129.25 Mn * (1 / 5%)
- = $2,584.93 Mn
Therefore, the calculation of Intrinsic value for the company will be as follows –
Calculation of Intrinsic Value for the Company
- Value of the company = $2,504.34 Mn
After this, we will do the calculation of Intrinsic value per share, which is as follows –
Calculation of Intrinsic value per share
- Intrinsic value formula = Value of the company / No. of outstanding shares
- = $2,504.34 Mn / 60 Mn
- = $41.74
Therefore, the stock is trading below its fair value, and as such, it is advisable to purchase the stock at present as it is likely to increase in the future to attain the fair value.
Relevance and Use of Intrinsic Value Formula
The value investors build wealthWealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation. by purchasing fundamentally strong stocks at a price way below their fair value. The idea behind the formula of intrinsic value is that the market usually delivers irrational prices in the short term. Still, in the long run, the market correctionThe Market CorrectionMarket Correction is usually referred to as a fall of 10% or more from its latest high. It happens due to various reasons such as declining macro-economic factors, intense pessimism across the economy, securities specific factors, over-inflation in the markets, and so on. will happen such that the stock price, on average, will return to its fair value.
Frequently Asked Questions (FAQs)
If there is a significant demand for investments, the market value will often be higher than the underlying value, sometimes leading to overvaluation. The converse is true if there is a lackluster demand for investments, which may lead to an undervaluation of the business.
One of the challenges with value is that intrinsic computing is a very individualized process. Several assumptions are used to predict the cash flow. Therefore, modifications in these assumptions will impact the ultimate net present value.
When the stock’s intrinsic value and potential for growth are considered, fair value—the price an investor pays for a share—can be regarded as the stock’s current value. The intrinsic value is determined by multiplying the dividend amount for the following year by the rate of return, less the growth rate.
This article has been a guide to what is Intrinsic Value Formula. Here we discuss how to calculate the Intrinsic Value of Business and Stock using practical examples and downloadable excel templates. You may learn more about Valuations from the following articles –
- Net Asset FormulaNet Asset FormulaThe net asset formula evaluates the company's total assets surplus or deficit over its total liabilities. It determines the company's net worth or value which is an indicator of its financial health.
- Enterprise Value Calculation
- Gordon Growth Model Formula
- Time Value of Money Formula