The intrinsic value of a stock is defined as the true worth of a stock based on established financial information and clear forecasts about the business.
In practice, there are many ways of calculating intrinsic value, giving a range of results depending on the method and the input parameters. Therefore intrinsic value is thought of as the result of any calculation that evaluates the worth of a stock according to a specific method with specific inputs.
Some of these methods of calculating intrinsic value are shown in the figure below:
The basic assumption of intrinsic value is that, over time, the price of a stock will move towards its intrinsic value. The secondary assumption is that stocks that are more undervalued will initially rise in price more quickly than those that are less undervalued.
It is the relationship between intrinsic value and price that determines value. It is up to each individual investor to compare intrinsic value with market prices to make the most profitable transactions.
Many people think that intrinsic value is not necessary, because –
- Some believe that levels and movements of share prices have patterns and irregularities that, properly understood, they can predict whether the stock is going to go up, stay same or stay down.
- The other view is that stock prices are random and no profitable trading strategies are possible based on price movements.
- A third view is that price levels are due to the collective mood of the investors
However legends of investing like Warren Buffet and Benjamin Graham are of the view that calculation of intrinsic value is the essential first step in being a successful investor.
notes from the book, “The Conscious Investor” by John Price