Intrinsic value formula can help one to estimate ‘fair value’ of stocks. But why to bother about ‘intrinsic value’? Why not simply buy stocks at an available market price?
Because stocks will be profitable only if one buys them at a price below its intrinsic value. In fact, Benjamin Graham (The Guru to Warren Buffett) says that, stocks must be bought at a ‘discount‘ to its intrinsic value.
What means by discount? Suppose a stock’s market price is Rs.100. Upon estimation, its intrinsic value comes out to be Rs.90. In couple of months, market price of this stock fell from Rs.100 to Rs.80.
At this price level, the stock is said to be trading at a discount of 11.1% to its intrinsic value [(90-80)/90].
Market price is the current price of a stock at which one can buy and sell it. There is no partiality here. Even Warren Buffett has to buy stocks in stock market at its ‘market price’, like us.
But the difference between Buffett and us is in the awareness about intrinsic value. Warren Buffett will never buy a stock without knowing its intrinsic value. Why? Because he buy’s only those stocks which are available at a discount to its intrinsic value [Market Price less than Intrinsic Value] .
Intrinsic Value (Undervalued Stocks)
Warren Buffett aims to buy stocks at a price below its intrinsic value. Such stocks are called undervalued. What is the utility of undervalued stocks? Price of such stocks has a stronger tendency to move-up over time.
There can be two stages of price moving up:
- Levelling with Intrinsic Value: The first stage will be when the market recognises that the current stock price is undervalued. In this case there will be more buyers for this stock than its sellers. Hence its price will start moving up. This upward price momentum will continue till market price equals the intrinsic value. Read more about the concept of intrinsic value of stocks.
- Move towards overvaluation: Price of undervalued stocks will rise till it levels with its intrinsic value. This is like a certain logical growth. But often the forward momentum takes the price beyond the intrinsic value levels. This is where the stock starts to become overvalued. Read more about how to identify undervalued stocks.
For potential investors, the target should be to identify an undervalued stock, and buy it at a ‘discount’. Such stocks has greater potential to give delta returns as highlighted in the above infographics.
Intrinsic Value Formula
There is a book on value investing called “The Intelligent Investor“. This book is written by Benjamin Graham (The Guru to Warren Buffett). In this book he has mentioned a formula. This formula can be used to estimate intrinsic value.
The formula looks like this:
V = EPS x (8.5 + 2g) – (i)
- V = Intrinsic Value.
- EPS = Earning Per Share.
- 8.5 = Assumed fair P/E ratio of Stock.
- g = Assumed future growth rate (7-10 years).
In year 1962, Benjamin Graham updated the above formula to make it more flexible for future use. He inserted a ‘multiplying factor’ in the original formula. He called the multiplying factor as interest rate factor. After this small tweak, the updated formula looks like this:
- 4.4 = Interest Rate of AAA Corporate Bonds in USA in Year 1962.
- Y = Interest Rate of AAA Corporate Bonds in USA as on today.
Ben Graham’s Formula Updated for India
The above formula has many limitations. Experts of fundamental analysis of stocks prefer going into more detailed calculation to estimate intrinsic value. Read more about doing detailed stock analysis in MS Excel.
In the above formula of Benjamin Graham, there is a factor of “4.4”. This makes it suitable for stocks trading only in USA. There must be a different factor for Indian stocks, right? Why?
Because in the denominator there is a factor of “Y”. What is Y? Interest rate of AAA corporate bonds operating in a country (for us it is India). Hence, the numerator must also be tweaked for India.
Hence, I though to use a slightly different form of this formula for my stock’s analysis. But the problem was, nowhere I could find the yield of AAA Corporate bonds of India in 1962. So I thought to use the below assumption to reconfigure the multiplying factor:
Hence the revised Benjamin Graham’s intrinsic value formula looks like this:
[Intrinsic value calculator based on Benjamin Grahams Formula]
Benjamin Graham’s intrinsic value formula is only a starting point of stock valuation. It can only give a rough idea of the intrinsic value of stock. But one must not base their decision on this formula alone.
It is better to cross check true value of stocks by using more detailed tools of fundamental analysis. I personally use my stock analysis worksheet to do a more detailed analysis of my stocks.