How to Calculate Intrinsic Value
Intrinsic value is a key concept in value investing, representing the true worth of an asset based on its fundamentals. Here are the steps to calculate it:
1. Understand the Components
Intrinsic value can be derived from various models, the most common being Discounted Cash Flow (DCF). This approach requires:
- Future cash flow projections
- Discount rate (often the weighted average cost of capital)
- Terminal value for cash flows beyond the forecast period
2. Project Future Cash Flows
Estimate the company’s future cash flows for a specific period, typically 5-10 years. Consider growth rates based on historical performance and industry standards.
3. Calculate the Discount Rate
The discount rate reflects the risk associated with investing in the asset. This can be calculated using models like the Capital Asset Pricing Model (CAPM).
4. Calculate the Present Value
Discount the future cash flows back to the present value using the formula:
PV = CF / (1 + r)^n
Where PV is the present value, CF is cash flow, r is discount rate, and n is the year.
5. Determine Terminal Value
Estimate the value of the company at the end of the projection period, often using a perpetuity growth model, and discount it back to present value.
6. Sum Up the Values
Add the present values of projected cash flows and terminal value to arrive at the intrinsic value of the asset.
By comparing this intrinsic value with the market price, investors can identify undervalued or overvalued assets.