Have you ever heard of “overvalued stock” or for that matter the relative term “undervalued stock”?

Being a payer of stock market and asset trading investor, you might have come across terms like “correction in stock price”.

Wondering why and how do you judge if the price of the stock is overvalued or is lower than the optimal price and who gets to decide the optimal price? 

Here is what we call the magic of intrinsic valuation.

What is intrinsic value? 

Intrinsic value in general terms means the true or base value of anything. In financial terms, we refer to intrinsic value as the true value or worth of the asset at any given point in time. 

For understanding, we can claim that ABC ltd. stock price intrinsic value is at $55 depending upon proper judgement and analysis of financial statements.

Now if the trading price of this ABC ltd. company’s stock is at $60, we say that the stock is overvalued may be due to any new commitments or positive announcements by that affect companies reputation. 

Whereas, if the stock trading price lies at $45 for a substantial time, we might see analysts talking about the undervaluation, this again due to external news factors. 

Therefore the intrinsic value is the base true worth of any given asset assessed after considering a thorough analysis of all factors. 

Once the overvaluation or undervaluation is captured by the market, the market being volatile, realises the faults and the price of assets in trading starts to correct itself over time.

The correction happens till the time the trading prices reach nearest to the assessed intrinsic value. 

What is discounted cash flow? 

It is an accounting term that many of the company accountants and even big stock market players use to assess the future prospects of cash balances of a company. 

Discounting is a technique to know the future value of cash flows of any given company depending upon its current value and near future projects.

This is affected by cashflows and revenue models with expectations of profit or underlying calculations of cash assets. 

This includes discounted rates depending upon expectations of the future health of cash flow statements and revenue generation. 

Discounted Cashflow technique helps to know the intrinsic value of the investment based on how well its cash positions will perform. 

From a general investor perspective, the purpose of investments is to let the money invested grow by itself and give possible returns regularly.  

This assumption of investors brings us to the assessments of discounted cashflows known as DCF in accounting language. 

With DCF, the value of an asset is the present value of its expected future cash flows, discounted using a rate that reflects the risk associated with the investment. 

The intrinsic valuation with the DCF technique requires majorly fundamental analysis of the company issuing assets for public investors and is, therefore, an overview of its performance.

Discounted cash flow models use cash flows and the weighted average cost of capital. The weighted-average cost of capital is the expected rate of return that investors want to earn that’s above the company’s cost of capital.

How to calculate the intrinsic value using DCF

The calculation of intrinsic values depends on cash flows and future prospects as discussed above, we require three major things:-

1. Future value of cash flows – estimating future cashflows means using 12 months cashflows generally with respect to assuming some percentage of growth rate that is acceptable under the company’s revenue standards. 
2. Discount rate to convert the future value into the present – Intrinsic value is highly sensitive to the chosen discount rate. The lower the discount rate, the higher the value.
3. Valuation of the company as a whole – terminal value often based on a multiple of the cash flows in the final year.

 The formulas go as:-

DCF = CF1/(1+r) + CF2/(1+r)2 + …….+ TV/(1+r)n

this formula is based on 

CF – cash flow in different years that is year 1,2….n

r  – the discount rate 

TV – terminal value, is the  value of cash flow of the company for the end year

Pros and cons of discounted cash flow method

Pros: 1. It determines the true value of the company and therefore makes it easier to make investment decisions over a long term basis. 

2. Helps companies calculate the internal rate of return (IRR) on investments, that they can compare the competing investment plans
3. You need not invest your time looking at comparable firms and focus on one at a time for real values and real best decisions. 

Cons: 1. The intrinsic value phenomenon is subjective to its use over investment commodity. 

Like gold and silver and some other precious metals are used as investments and trading but have no intrinsic value, such cases are excluded from the intrinsic value analysis and such commodities cannot be used for over or undervaluation. 

2. Moreover, the intrinsic value depends on factors like terminal cash flows, which is quite a task that can be heavy upon expectation errors or underperformance in reality over expectations. 
3. Working with a weighted average cost of capital can again use numerous assumptions and therefore can restrict the valuation to a certain set of parameters. 

Relative vs intrinsic valuation 

Relative valuation is the type of valuation that needs industry comparisons, meaning the company or the instrument’s worth is compared with that of comparable industry statistics. 

Relative valuation works over ratios, averages, financial comparisons with industry peers and benchmarks. 

Whereas, intrinsic valuation regards the true value of a company without looking for comparable statics over the industry. 

The only key difference is in the style of valuation bases. 

Bottom line 

Covering up how intrinsic valuation helps in knowing the true worth of the asset will save your pennies from getting eroded away in a differential market short term trends. 

Some real value numbers are also beneficial to come up with decisions occurring over value investing with long term returns in mind. 

However, the restrictions to the financial model will continue to keep hindrance over how the intrinsic value is estimated with the discounted cash flow method.