What is the intrinsic value of shares?
Intrinsic value – When I heard it for the first time, I was afraid but thankfully when I understand it. It was easy.
First, understand the market price of the shares- It is the price at which we buy and sell shares. And it fluctuates every day, a share was 4% up, then 5% down. Now, this gets affected if there is news or something good or bad happens in the industry. Or rumors like Rakesh Jhunjhunwala buying this share would make it go up or vice versa. So because of these rumors, the market price fluctuates.
But due to this, the company’s value doesn’t go up or down by 5%. If Colgate is selling toothpaste, then its share would see a jump or fall of 4%, but Colgate as a brand wouldn’t fall or jump. This shows us that we cannot make market price a measure to buy a share. We have to buy the share on the real value of the company. And this real, fair value is called the intrinsic value.
Why the intrinsic value of shares is important?
It is important because if we do not negotiate then we won’t get the best rates. And we Indians know it better. May it be vegetables or Jewellery, we negotiate and get satisfaction as well as best rates. If we keep on buying at the started rate, then we might go bankrupt. Similarly, if we buy the share on the market price. So we have to buy our share at the price which suits us best.
For example, when you go out shopping, a saree would seem fine at 1000 to you. But the same might feel fine qt 1100 to another one. Which states that everyone has a fair value according to them. Now it may be at 1500 but to buy it at 1100, 1200 is an individual decision. just like people have different intrinsic values for fruits, clothes, in that sense, only the value for Colgate might be different for others.
The first point about intrinsic value
The first point about intrinsic value is that there is no fixed scientific theory on intrinsic values. This can be your choice, it’s an art, not a fixed number.
How to find out the intrinsic value?
There can be many methods and which one is right or wrong is not fixed. So according to the business model, how conservative are you, which method is relevant to you. Let’s start with the easiest.
The first method is book value method
Assume there is a car that totally scraps and doesn’t even work. What will be the cost of the car? It would be only the price of the steel it is made of. Meaning the value of steel that day multiplied the amount of steel. It has is the intrinsic value of the car. This method of calculating is called the book value method. Meaning that how many assets the company has and adding all the assets value is the company’s intrinsic or fair value.
Many follow this method, but in a bull run, you might not feel it viable. If you think logically of weighing a BMW or Mercedes with this measure. Then it would feel very overvalued. And if you apply the same approach, you would feel the companies are overvalued. So this method is suited best for companies dealing in metal, land, oil, all-natural resources company can be valued.
The second method is relative valuation
Remember whenever your parents send you to buy vegetables. We ask for how much for a kg of Bhindi, okay Rs 40 and Barbati for 30. Even if they are diffrent vegitables. We compare different vegetables and make out to eat the cheaper ones. Because if we don’t get Barbati well eat Bhindi and vice versa because they are supplementary. Because the need fulfill and if we are considering Bhindi expensive it is in relation to Barbati. We are comparing two different vegetables wanting either them to be the same amount or a slight difference.
And this is what we do in the share market. Relative valuation if the companies are close in size. Both are similar in revenue, profits have no debt. Basically, we can compare them, one earns 100 the other earns 80. But I am getting both the companies for Rs 1000, the company earning 100 seems better and undervalued. And the company earning 80 seems a bit expensive. Meaning it earns 20% less soo the value should also be less and it should be at 800.
Assuming both companies are identical and it i9s not this ideal in the real world. It is just an example for understanding. And this can also not be a single measure to buy a share if the market is undervaluing a share you should keep checking on any misses. Because when the first time we buy vegetables and bargain good but when it turns out to be rotten or infected. Then we realize it’s not only about cheap but also about quality. This is the same mistake we do while valuing.
The third method is comparison with other asset classes
If tomorrow an FD gives you a return of 15%, you won’t be investing in mutual funds or stocks. When you are getting a risk-free return of 15% then why take the risk for the same. We find mutual funds or stocks attractive because an FD gives a 5% return. Last 7 to 8 years from now the past, FD’s used to give 10% returns. So we used to expect 20% from stocks. So we used to try to buy high growth companies cheap. Because if they grow 10 to 20% we use to think this much we get in an FD. Today when risk-free returns have fallen you will value a company that has grown only 12%. The value of stocks also depends on how other asset classes are behaving.
If gold crashes 50%, it would become viable to buy. Then most of the money would shift to gold from the stock market.
So a lot of things are dependent on how other asset classes are behaving. Because we all have a limited amount of cash and that has numerous uses. It can be put into real estate, bonds, FD, gold, stocks. We have 5 to 6 options but limited cash. We will shortlist the one which is the cheapest and invest. So the intrinsic value of the stock is also impacted by how other asset classes behave.
The fourth method is Future earning of the company
Let’s understand through an example. You want to buy a shop and you know you would be getting a rent of 1 lac per year. And you will be getting 10 lacs in the coming 10 years. Meaning you know the future earnings of the business. Now it depends on you that for that 1 lac a year, in how much will you buy it now?. And that would be the intrinsic value and this is called discounted cash flow method. And discounted because we are determining today’s value basis future earnings. Cash flow is the cash you are getting discounting it for future earnings. SO these were a few simple methods to determine the intrinsic value of a share.