When evaluating a company or investment, the market price is not always the same as what the asset may be worth based on its fundamentals. This is where the concept of intrinsic value becomes useful.
Intrinsic value is an estimated value based on factors such as future cash flows, earnings, growth expectations, and the required rate of return.
In this article, we'll look at what intrinsic value means and how it can be calculated using common valuation approaches.
What Is Intrinsic Value?
Intrinsic value is an estimate of the underlying worth of an asset based on its fundamental characteristics rather than simply its current market price.
For a company, this can involve analyzing:
Expected future cash flows
Revenue and earnings
Growth potential
Debt and other financial obligations
Required rate of return
Long-term business prospects
The calculated value is an estimate, not a guaranteed future price.
Why Is Intrinsic Value Important?
Market prices can change because of news, investor sentiment, economic conditions, and other factors.
Intrinsic value provides another perspective by focusing on the underlying financial fundamentals.
For example, if an estimated intrinsic value is higher than the current market price, an investor may consider the asset potentially undervalued. If the estimated intrinsic value is lower, it may be considered potentially overvalued.
However, the conclusion depends heavily on the assumptions used in the calculation.
*How to Calculate Intrinsic Value
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There are several approaches to estimating intrinsic value. One widely used method is the Discounted Cash Flow (DCF) method.
The basic process involves the following steps.
*1. Estimate Future Cash Flows
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First, estimate the amount of free cash flow a company may generate in future years.
For example, suppose a simplified company is expected to generate:
Year 1: $10 million
Year 2: $11 million
Year 3: $12 million
Year 4: $13 million
Year 5: $14 million
These figures are only hypothetical and are used to demonstrate the calculation.
*2. Choose a Discount Rate
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Future money is generally worth less than money available today because of the time value of money.
A discount rate is therefore used to convert future cash flows into their estimated present values.
For example, suppose we use a discount rate of 10%.
The present value of a future cash flow can be represented as:
PV = Future Cash Flow / (1 + r)^n
Where:
PV = Present Value
r = Discount Rate
n = Number of years
- Calculate the Present Value of Future Cash Flows
Each projected cash flow is discounted back to its present value.
For example:
PV₁ = FCF₁ / (1 + r)^1
PV₂ = FCF₂ / (1 + r)^2
The same calculation is performed for each projected year.
The present values are then added together.
*3. Calculate Terminal Value
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A company may continue generating cash flows beyond the explicit forecast period. The terminal value attempts to estimate the value of those future cash flows.
One commonly used perpetual-growth formula is:
Terminal Value = FCFₙ × (1 + g) / (r - g)
Where:
FCFₙ = Cash flow in the final forecast year
g = Long-term growth rate
r = Discount rate
The terminal value is then discounted back to its present value.
*4. Calculate Enterprise Value
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The discounted future cash flows and discounted terminal value can be combined to estimate enterprise value.
In simplified form:
Enterprise Value = PV of Forecast Cash Flows + PV of Terminal Value
*5. Calculate Equity Value
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If you're calculating the value attributable to shareholders, adjustments may be needed for items such as debt and cash.
A simplified relationship is:
Equity Value = Enterprise Value - Net Debt
*6. Calculate Intrinsic Value Per Share
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Finally, divide the estimated equity value by the number of outstanding shares:
Intrinsic Value Per Share = Equity Value / Shares Outstanding
This gives an estimated intrinsic value for each share.
Example
Suppose a simplified valuation produces:
Enterprise Value = $500 million
Net Debt = $100 million
Equity Value = $400 million
Shares Outstanding = 20 million
Then:
Intrinsic Value Per Share = $400 million / 20 million
= $20 per share
The estimated intrinsic value would therefore be $20 per share.
This value can then be compared with the current market price as one part of a broader analysis.
Other Ways to Estimate Intrinsic Value
DCF is not the only approach.
*Dividend Discount Model
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The Dividend Discount Model (DDM) estimates value based on expected future dividends.
It can be particularly relevant for companies with relatively stable and predictable dividend payments.
*Earnings-Based Approaches
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Another approach is to estimate a company's value using expected earnings and an appropriate valuation multiple.
For example:
Estimated Value = Expected Earnings × Appropriate P/E Multiple
The challenge is selecting realistic earnings estimates and a suitable multiple.
Asset-Based Valuation
For some companies, especially businesses with substantial tangible assets, intrinsic value can also be considered using the value of assets minus liabilities.
Important Factors to Consider
Intrinsic value calculations depend heavily on assumptions.
Small changes in assumptions about:
Growth rate
Discount rate
Future cash flow
Terminal growth
Debt
Earnings
can produce significantly different results.
This is why a single intrinsic-value number should not automatically be treated as an exact measure of what an asset is worth.
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Final Thoughts**
Calculating intrinsic value provides a structured way to think about the fundamental value of a company or asset.
The DCF method is one of the most commonly discussed approaches because it connects valuation with expected future cash flows and the time value of money.
For beginners, the most important thing is to understand the logic behind the calculation rather than focusing only on the final number.
For a more detailed explanation of the formulas and calculation process, you can explore the How to Calculate Intrinsic Value guide on TPointTech.
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