Intrinsic Value of a Stock: Step-by-Step Guide to Finding Undervalued Stocks

Intrinsic Value of a Stock: Step-by-Step Guide to Finding Undervalued Stocks

 When it comes to stock investing, one of the most important aspects of building a portfolio is focusing on long-term horizon opportunities. This is where the intrinsic value of a stock comes into play. Knowing this metric helps with spotting undervalued opportunities. It is important to know how to calculate intrinsic value. This guide provides the stock valuation methods and principles of a value investing strategy to help you locate the undervalued stocks India has to offer. With this guide, you will be able to find stocks that are trading for less than their value and this will help you gain significant returns.

What is a Stock's Intrinsic Value?

Essentially, the intrinsic value of a stockis the actual value of the company based on its fundamentals and not the arbitrary value of the company based on its current market value. This value, originally coined by the legendary investor Benjamin Graham and made famous by Warren Buffett, is an estimate of what a stock should be valued at based on all future cash flows, assets, and growth potential.

The market price of a stock is considered a sticker price on a car and is influenced by emotions, news, and speculation. The intrinsic valueis considered the actual value beneath the hood and the value that the engine, build quality, and overall car longevity adds. When the market price is below this intrinsic price, a stock is said to be undervalued and is a candidate for investment.

When a stock is said to be undervalued, it can be a good candidate for investment. In fast-moving and unpredictable markets, like the current Indian market, relying on market prices alone can lead to investments that are poor and not well thought out. This is why calculating the intrinsic value of a stockis important, as it eliminates the noise and focuses on important things such as earnings, dividends, and growth rate.

Why Figure Out Intrinsic Value

However, before we explain how to calculate intrinsic value, we want to explain why it is essential. A Value Investing Strategy will have the investor buy and sell at a profit. Selling at a profit is defined by the investor's entryvalue at which they purchased the stock. Selling at a profit occurs when the stock value increases.

With the IT, pharmacy, and renewable energy sectors exploding, the diversification of the Indian economy has accelerated quickly. Value investors in the Indian market have a high risk, high-reward potential by trapping in undervalued stocks. An example of this is when blue-chip companies are undervalued.

To protect yourself from overvalued stocks, it is essential to calculate intrinsic value. There is bound to be a Dot-com bubble again, along with the new trending stock bubble. Investors ignore fundamentals and end up losing a large amount of money. An investor with a disciplined approach in stock valuationis less likely to lose a large amount of money again.

Methods for Valuing Common Stock

Numerous methodologies for valuing equity can be used to determine stock value. Each theory has its merits based on a company's developmental stage and provided metrics. Described below are the most used stock valuation methodologies.  

1. Discounted Cash Flow (DCF) Analysis

The industry standard for how to calculate intrinsic valueis the Discounted Cash Flow Method. The DCF method values a company's expected cash flows and uses a discount rate to determine the present value. This is optimal for mature companies that can be expected to yield a stable stream of revenue.  

2. Dividend Discount Model (DDM)

The DDM is a variant of DCF that concentrates on dividends. This method works best for dividend-paying stocks that are prevalent in the Banking and Utilities sectors in India.

3. Price to Earnings (P/E) Ratio

Valuing a stock based on its relative earnings per share (EPS) creates the Price to Earnings Ratio. A stock that is priced low relative to its earnings (low P/E) may be considered a good investment, provided that the P/E is evaluated against the industry benchmark.  

4. Price to Book (P/B) Ratio

The Price to Book Ratio allows the evaluation of stocks in the real estate and manufacturing sectors. The P/B ratio values the market price against a company's book value (assets - liabilities).  

5. Earnings Power Value (EPV)

The Earnings Power Value (EPV) is a method of valuing a company based on its expected stream of earnings. This model assumes that a company's earnings will remain constant into perpetuity. This method is best suited for a company with a cyclical business model as it is considered to be an underestimation of revenue.

In India, where SEBI and other regulatory bodies offer free and clear access to financial data, these techniques can be seen on Moneycontrol and NSE India. The most precise intrinsic value of a stockis derived from a combination of several stock valuation techniques.

Step-by-Step on Finding Intrinsic Value Using DCF

Let’s get to the meat of this and give you a roadmap to find intrinsic valueby DCF. It is a bit involved, but it is very useful when trying to find stock valuation India.

Step 1: Financial Data Collection 

Collect the following parameters from the company’s website/annual report/financial website:

- Free Cash Flow (FCF): cash flow from operations less cash used for capital expenditures.

- Growth Rate: historical and expected future revenue/earnings (e.g., 10-15% for Indian mid caps).

- Discount Rate: This is mostly the Weighted Average Cost of Capital (WACC). In India, it is 10-12%, plus a cushion for inflation and risk.

- Terminal Growth Rate: for India, it is 5-7% of long-term GDP growth.

Let’s take an example of an Indian IT company, which is hypothetical, Infosys. Consider its last 5 years' FCF from the BSE filings.

Step 2: Estimation of Cash Flow

Make a prediction for your future cash flow for 5-10 years. To do so, use a growth rate:

- Year 1: (Current FCF (1 + growth rate))

- Year 2: Year 1 FCF (1 + growth rate)

- Continue this for each year

As an example, for Year 1 with a current FCF of 100 crore rupees and a growth rate of 12%, Year 1 would be 112 crore rupees. 

Step 3: Calculation of Terminal Value

Estimate the terminal value. This value is perpetual, so use the Gordon Growth Model, which states:

Terminal value = final year FCF (1 + terminal growth)/(discount rate - terminal growth).

For example, this would be 200 crore rupees (year 10 FCF) (1 + 5%)/ (10% - 5%) or 4,200 crore rupees. 

Step 4: Present Value Calculation

The value of each projected terminal value and future FCF is discounted: 

Present Value = Future Value / (1 + discount rate)^n 

The total enterprise value is the sum of these discounts. 

Step 5: Debt Cash Value Adjustment

The intrinsic value is the enterprise value - net debt + cash.

Divide by the outstanding average shares of the company to determine the intrinsic value per share.

Step 6: Value Comparison

The principal value versus its current estimated value can be compared. If the value is intrinsic > the value in the marketplace, then it is undervalued. It is wise to apply a margin of safety, so a value that is 20 - 30% under the intrinsic value would be wise. Tools such as Excel or online calculators make doing the calculations easier. You will also need to consider the depreciation of the rupee and sector-specific risks when it comes to stocks in India. Get some practice on a real example, Reliance Industries. 

Discovering Undervalued Stocks in India

When it comes to undervalued stocks in India, you need to have some market-specific knowledge of the stock market in India, as it has over 5,000 listed companies. There is a lot of potential for growth in the emerging sectors. 

The first thing you should do is see which stock has the lowest P/E or P/B ratio compared to its counterparts, as well as which companies have a high return on equity (ROE) greater than 15% and a consistent growth in earnings. 

There are also some tools on the internet, such as Screener or Tickertape, which make it easier to find stocks. When stocks have been devalued or adjusted, look for smaller-cap stocks. PSUs have also been undervalued during their reforms. 

Some stocks that are undervalued as of now are: 

- Banking: SBI is a stock that, during economic slowdowns is often found to be below book value.  

- Pharma: Sun Pharma has been known to have a strong pipeline, but it also has some temporary setbacks.

- Auto: Tata Motors is considered to be undervalued because it is also in a cyclical growth phase. 

When it comes to a value investing strategy, you will need to be patient for the market to recognise and appreciate your efforts and the value of your investment. Look for how quality the management is, consolidate efforts to have a competitive edge (for example, patents and copyrights).

Constructing a Value Investing Strategy

A strong value investing strategy focuses on the intrinsic value of a stock. This approach was first applied by Graham and Buffett. This involves: -

Diversification: A spread of 10-20 stocks for risk mitigation.   

Margin of Safety: Buying at 70-80% of the stock's intrinsic value.   

Long-Term Horizon: Volatility is to be ignored in the short-term, and focus on the next 3-5 years for compounding.   

Continuous Learning: Valuations should be updated frequently with new information.

Conclusion

Finding cheap stocks in India and carrying out a profitable value investing plan requires an understanding of a stock's inherent value. You get an advantage in a cutthroat market by using stock valuation techniques like DCF. Keep in mind that investing is a marathon; perseverance and self-control are key.

DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.