3 Things You Need to Know before You Calculate a Stock’s Intrinsic Value
Here’s a question.
Let us say, you found a good stock: ABC Ltd. It is trading at $ 10 a share. Is it a good time to buy, to hold or to sell shares of ABC Ltd?
I believe, there are numerous ways to answer this question depending on the investment methods chosen. If you are a fan of Warren Buffett, you would be calculating the intrinsic value of a share for ABC Ltd as it helps to determine whether ABC Ltd is undervalued or overpriced at $ 10 a share.
If the intrinsic value is calculated to be $ 15, an investor would be interested to buy ABC Ltd as its shares are deemed to be undervalued. However, if the intrinsic value is calculated to be $5, an investor may choose to dismiss ABC Ltd as an investment as its shares are deemed to be overpriced. In fact, if the investor has shares of ABC Ltd, he may consider disposing them to reap his investment rewards.
The logic is simple. But, the formula to calculate a stock’s intrinsic value is not as straightforward and is often misused. Thus, in this article, I’ll share 3 basic things you need to know first before you calculate a stock’s intrinsic value. They are:
It’s for Growth Investors
First, you must understand that the intrinsic value formula is not meant for everyone. It is best used for investors who seek to build long-term wealth via ownership of fundamentally solid stocks. This formula is not suitable for you if you intend to speculate, do day-trading, do swing trading, or even to some extent, invest for dividend yields.
It’s for Stocks that Grow Profits Consistently
Second, you must understand that this formula is not meant for every stock that is listed on the stock exchange. It is limited to stocks that have delivered consistent growth in profits. A stock’s consistency in growing profits is often assessed by taking a period of 10 years. Why? This is because, from which, an investor would be able to calculate its earnings growth rate. It is a vital piece of the component to be included in the formula of calculating intrinsic value.
Every now and then, I would receive questions on whether the intrinsic value is calculable for stocks that reported huge volatility in profits or for stocks that incurred losses. My answer is simple. It is a straight ‘No’. Is this a drawback of the formula? Personally, I view it positively. This is because I believe that the formula is supposed to encourage investors to minimize investment mistakes by avoiding bad stocks and to maximize investment profits by focusing solely on stocks with superior financial results.
It’s an Estimate
Savvy investors know that the intrinsic value figure of a stock, let’s say ABC Ltd, is an estimate and would be used as a guide. There is no guarantee that the stock price of ABC Ltd would eventually hit the intrinsic value estimated by each individual investor.
This is because the intrinsic value formula involves making assumptions and educated guesses. This includes earnings growth rate and the discount rate used in the computation. In most cases, different investors would make different assumptions, thus, resulting in different intrinsic value figure of a stock. This is despite using the same financial reports released by the same stock.
The Foolish Takeaway
Obviously, I have just covered the tip of the subject on intrinsic value. There are so much more to be discovered.