Before deciding to buy stocks, an investor first needs to know what is the inherent or the intrinsic value of the share he or she intends to buy.
So let us address the concepts one by one.
But how can we say this with conviction?
Well, will any sane person take a 500 rupee note and exchange it for more than five 100 rupee notes? Similarly, will we accept four 100 rupee notes in return for a 500 rupee note?
Therefore we can safely conclude that the intrinsic value of a five hundred rupee note is equal to 500 one rupees or five hundred one rupee notes.
Intrinsic Value of Share
As with the five hundred rupee note, a share also has an intrinsic value. Any wise investor, who knows the inherent value of a share will never buy the stock above its intrinsic value. She will be glad to buy the share if it is trading in the stock market below its intrinsic value. Buy is an understatement, in fact, she will pounce on the opportunity and grab the shares with both her hands.
But, is it possible that shares can be available below their intrinsic values?
Of course yes!
The stock market is a highly irrational place.
Now the discussion is getting excited with the prospect of being able to buy stocks below their fundamental values, is it not?
So, now it is important for us to know how to calculate the intrinsic value of shares, and let us address the question.
Calculating Intrinsic Value of a Share
The intrinsic value of the share of a company is essentially calculated based on two factors as follows:
Example of Finding Intrinsic Value of a Share
Let us consider a live example of SJVN Ltd. and NMDC Ltd., based on the facts existing on 23rd September 2016.
In case of NMDC Ltd., to be on the safe side we have taken the minimum of the two intrinsic values of Rs.68.80 and 113.34 and rejected it. However please note that NMDC Ltd. is a wonderful company. I continue to buy its shares even today. Its PE Ratio deteriorated on account of two recent and temporary developments as follows:
- The EPS deteriorated steeply on the back of a meltdown in global commodity prices. The price of iron ore has recovered to a great extent and I firmly believe it regain further.
- The Indian stock markets have rallied in the recent past and pushed up the prices of all the shares across the board, which has pushed up the PE Ratio.
We should not make Investment decisions simply based on the intrinsic value calculations shown above. We should make a rigorous investigation of the company’s past performance and prevailing market conditions before making the investment. I have described this investigation in the article “Essential ResearchBefore Investing”.
Links to Related Posts
- Fair Price of Stock
- Price to Earnings Ratio Presentation
- Calculate Price to Earnings Ratio
- Calculate ‘Earnings Per Share’
- Definition of Book Value per Share
- Price to Book Value Article
To conclude, Price to earnings and Price to Book Value Ratios are the two key metrics employed in finding the intrinsic value of the shares of a company. We also learnt how to calculate the intrinsic value of a share.