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How to Find the Intrinsic Value of Stock?

One five hundred rupee note is equal to five one hundred rupee notes. Everything has an intrinsic value. One

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.

 

Intrinsic Value
Everything in this world has an inherent value. For example, one 500 rupee note has a value of five one hundred rupees currency notes. Not a penny more or, not a penny less.

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 a share

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:

  1. Price to Earnings (PE) Ratio
  2. Price to Book Value (P2BV) Ratio

 

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.

 

Example of Finding Intrinsic Value of a Share

 

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:

  1. 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.
  2. 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.

 

Caution:

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

 

Conclusion

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.


9 Comments

Chinnadurai Konar – Sep 22, 2017

Hello, very good article. Btw, what is the formula used for A and B?

admin – Sep 22, 2017

Dear Mr.Chinnadurai
Thanks for the question.
Multiply the Earnings Per Share (EPS) by 10 to get ‘A’ and multiply Book Value Per Share by 1.5 to get ‘B’.
Thank you,
Anand

Ganesh – Sep 22, 2017

How to calculate put call ratio in money wise

admin – Sep 22, 2017

Dear Mr.Ganesh

Sorry, I do not trade in stocks and derivatives. I am a value investor and this blog is about value investing. Value investing is not related to call and put.

Thank you,

Brgds

Anand

SANJIT – Sep 22, 2017

Hi Mr. Anand, you have recommended SJVN Ltd. shares to buy over NMDC Ltd shares though the B values of both the stokes are higher than their A values. If so, can you explain in detail why SJVN shares then?

admin – Sep 22, 2017

Dear Mr.Sanjit
Thank you.
As value investors, we should always buy the shares at or below their intrinsic value. The market price of NMDC at Rs.105.30 is far in excess of its intrinsic value of Rs.68.80 (minimum of A=68.80 and B = 113.34).
Actually speaking both SJVN and NMDC are very good companies and figure in the Portfolio2K15. However, on September 23rd, 2016, NMDC was more expensive. And this is the reason why I advised to buy SJVN instead of NMDC.
Thank you,
Anand

SANJIT – Sep 22, 2017

Okay. You mean we can decide to buy a share when it’s Market Price is less than it’s A value (Intrinsic value based on 10 PE ratio). Am I write?

admin – Sep 22, 2017

Yes, you are right. But as I had mentioned in the article under the heading, “Caution”, you cannot invest simply based on the price being below the intrinsic value. The company should be researched thoroughly based on the value investing principles in the first place and it should qualify to be investment grade. Then the market condition should be favourable so that you can buy the share below its intrinsic value.

SANJIT – Sep 22, 2017

Thanks a lot.

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