Intrinsic value per share: Meaning, Criticisms & Real-World Uses

What Is Intrinsic Value Per Share?

Intrinsic value per share represents an estimate of a company's true underlying worth, beyond what its stock might be trading for in the public market. This concept falls under the broader financial category of Valuation, which seeks to determine the economic value of an asset or company. Unlike market price, which is influenced by supply, demand, and investor sentiment, intrinsic value per share is derived from a thorough analysis of the company's fundamental financial and operational health. It aims to quantify the inherent value of a business by evaluating its assets, liabilities, earnings power, and future prospects. Investors often compare a stock's current Market capitalization to its calculated intrinsic value per share to identify potential investment opportunities, particularly in Value investing.

History and Origin

The concept of intrinsic value per share is deeply rooted in the principles of Fundamental analysis, largely popularized by Benjamin Graham, often called the "father of value investing." Graham, a professor at Columbia Business School, developed these ideas in the wake of the 1929 stock market crash and the Great Depression. His seminal works, Security Analysis (co-authored with David Dodd in 1934) and The Intelligent Investor (1949), laid the groundwork for assessing a security's true worth independent of its fluctuating market price. Graham sought a systematic way to determine what a stock was truly worth based on "cold, hard numbers" rather than market sentiment.⁶ His work introduced the idea that a stock’s value should be based on a company's fundamental attributes, such as its assets, earnings, and Dividend payouts.

⁵## Key Takeaways

Intrinsic value per share estimates a company's true worth based on its fundamentals, independent of its market price.
It is a core concept in value investing, used to identify potentially undervalued or overvalued stocks.
Calculation methods range from simple formulas to complex models like Discounted cash flow analysis.
The determination of intrinsic value per share often involves subjective assumptions about future performance.
Comparing intrinsic value per share to the current market price helps investors make informed decisions, often focusing on a Margin of safety.

Formula and Calculation

While there is no single, universally agreed-upon formula for intrinsic value per share, one of the most well-known is a simplified formula proposed by Benjamin Graham for growth stocks. This formula attempts to estimate a company's value based on its Earnings per share (EPS) and expected earnings growth rate.

Graham's original formula:

V = \frac{EPS \times (8.5 + 2g)}{Y}

Where:

(V) = Intrinsic value per share
(EPS) = Trailing 12-month Earnings per share
(8.5) = Graham's established Price-to-earnings ratio for a no-growth company
(g) = Expected annual growth rate of earnings for the next 7 to 10 years
(Y) = Current yield of AAA corporate bonds (used to account for prevailing interest rates)

It is important to note that the constant values (8.5 and the historical AAA bond yield of 4.4%) in Graham's formula are based on market conditions from his era and may require adjustment for contemporary use. M⁴ore sophisticated methods for determining intrinsic value often involve multi-period Discounted cash flow (DCF) models, which project future cash flows and discount them back to a present value.

Interpreting the Intrinsic Value Per Share

Interpreting intrinsic value per share primarily involves comparing the calculated value to the company's current market price. If the intrinsic value per share is significantly higher than the market price, an investor might consider the stock undervalued, suggesting a potential buying opportunity. Conversely, if the intrinsic value per share is lower than the market price, the stock might be considered overvalued, prompting a potential sell decision or avoiding the investment.

The gap between intrinsic value and market price is a key focus for value investors, who believe that markets can be inefficient in the short term, creating opportunities for those who can accurately assess a company's true worth. This assessment typically involves a deep dive into financial statements, including the Balance sheet and Income statement, along with qualitative factors like management quality and competitive advantages.

Hypothetical Example

Consider a hypothetical company, "DiversiCo Inc.," with the following financial data:

Current Earnings Per Share (EPS): $5.00
Expected Annual Earnings Growth Rate ((g)): 7%
Current Yield on AAA Corporate Bonds ((Y)): 4.0% (or 0.04)

Using Benjamin Graham's formula:

V = \frac{5.00 \times (8.5 + 2 \times 7)}{0.04}

V = \frac{5.00 \times (8.5 + 14)}{0.04}

V = \frac{5.00 \times 22.5}{0.04}

V = \frac{112.5}{0.04}

V = 2812.5

In this hypothetical example, the intrinsic value per share for DiversiCo Inc. is calculated to be $2,812.50. If DiversiCo's current market price is, for instance, $1,500 per share, an investor might consider it significantly undervalued based on this intrinsic value calculation, indicating a potential investment. This assessment would typically be part of a broader Risk assessment to ensure all factors are considered.

Practical Applications

Intrinsic value per share is a foundational metric in several areas of finance and investing. Its primary application is in Value investing, where investors actively seek out companies whose market prices are trading below their estimated intrinsic values. This approach aims to capitalize on market inefficiencies and potentially generate long-term returns.

Beyond individual stock selection, the concept of intrinsic value informs broader investment strategies, including Asset allocation. Investors and financial advisors may use intrinsic value assessments to guide decisions on which asset classes or sectors appear fundamentally undervalued or overvalued, influencing portfolio construction. For instance, some asset management firms focus on how valuation levels, such as starting yields, can influence future expected returns of various asset classes.

³Furthermore, business owners and private equity firms often use intrinsic valuation methods when considering mergers, acquisitions, or divestitures. In these contexts, understanding the true underlying value of a business is crucial for negotiating fair terms.

Limitations and Criticisms

While intrinsic value per share offers a powerful framework for investment analysis, it comes with notable limitations and criticisms. One significant challenge is the inherent subjectivity involved in its calculation. The future Earnings per share, growth rates, and discount rates used in valuation models like Discounted cash flow are estimates and can vary widely based on different assumptions. Small changes in these inputs can lead to substantially different intrinsic value estimates.

Critics also point to the fact that market prices do not always align with intrinsic value in the short or even medium term, reflecting the influence of investor psychology, market sentiment, and macroeconomic events. The Efficient Market Hypothesis, for example, posits that asset prices reflect all available information, making it difficult to consistently find undervalued securities. W²hile value investors argue for eventual convergence, this can mean a prolonged period where a stock trades below its perceived intrinsic value.

Furthermore, intrinsic value calculations may not fully capture qualitative aspects of a business, such as brand strength, management quality, or competitive advantages, which can be difficult to quantify. Regulatory definitions of value, such as "Fair value" as defined in accounting standards, are often based on market participant assumptions and observable inputs, contrasting with the fundamental, sometimes unobservable, nature of intrinsic value. T¹his difference highlights the distinction between a market-driven valuation and a value derived from internal financial attributes.

Intrinsic Value Per Share vs. Market Price

Intrinsic value per share and market price are two distinct measures of a company's worth, often confused but serving different purposes in investment analysis.

Intrinsic Value Per Share focuses on a company's fundamental attributes and its ability to generate future earnings and cash flows. It is a subjective estimate derived from in-depth Fundamental analysis of a company's financial statements, business model, and competitive landscape. The intrinsic value aims to represent the "true" or "real" value of a business, independent of current market fluctuations or investor sentiment. It is what a rational investor believes the company is worth based on its underlying assets and earning power.

The Market Price of a share, conversely, is simply the price at which a stock is currently trading on a public exchange. This price is determined by the collective actions of buyers and sellers, influenced by factors such as supply and demand, news events, investor emotions, macroeconomic conditions, and prevailing interest rates. The market price is readily observable and constantly changing.

The confusion arises because investors often use intrinsic value as a benchmark against the market price. Value investors believe that when a stock's market price falls below its intrinsic value, an opportunity exists to purchase the stock at a discount. Conversely, if the market price is significantly above the intrinsic value, the stock might be considered overvalued. The relationship between these two values is central to identifying potential mispricings and executing a disciplined investment strategy.

FAQs

Q1: Is intrinsic value per share the same as book value per share?

No, intrinsic value per share is not the same as Book value per share. Book value per share is a historical accounting measure calculated as a company's total equity divided by the number of outstanding shares. It represents the value of assets minus liabilities as recorded on the balance sheet. Intrinsic value, on the other hand, is an estimate of a company's total worth based on its future earning potential, which may or may not align with its past accounting values.

Q2: Can intrinsic value per share change over time?

Yes, the intrinsic value per share of a company is not static and can change over time. It can increase if the company's profitability improves, its growth prospects strengthen, or its assets become more valuable. Conversely, it can decrease due to declining earnings, increased debt, or a deteriorating competitive position. Investors continually reassess intrinsic value as new financial information and market conditions emerge.

Q3: How do professional analysts determine intrinsic value per share?

Professional analysts often use more complex and detailed methods than simple formulas to determine intrinsic value per share. The most common method is Discounted cash flow (DCF) analysis, which involves projecting a company's future free cash flows and then discounting them back to their present value using an appropriate discount rate. Other methods include dividend discount models, asset-based valuation, and comparisons to similar companies (comparable company analysis). The choice of method often depends on the type of company and the availability of reliable data.