Intrinsic Value Formula

"How to calculate the intrinsic value of a stock?" is without a doubt the question that people ask me the most often. In this short article I will show you an easy intrinsic value formula that allows you to estimate the underlying value of a stock in the simplest way possible.

Stock price movements do not say much about the underlying business, that's why we want to know the value of the business instead.

To arrive at this so called intrinsic value, we'll start by estimating what the stock should realistically be worth in 5 years, based on its current earnings per share (EPS) and growth rate.

Then we'll discount that future value to arrive at a reasonable value for the stock today. Simple!

All we need are three inputs:

  1. Earnings per share (ttm)
  2. 5-year average price/earnings ratio
  3. Expected growth rate

These inputs come together in the following intrinsic value formula:

EPS x (1 + expected growth rate)^5 x P/E ratio

As an example, we'll calculate the intrinsic value of Apple Inc. (AAPL). At the time of writing, the inputs are equal to:

  1. Earnings per share (ttm): $11.89
  2. 5-year average price/earnings ratio: 15.4
  3. Expected growth rate: 12%

Entering these numbers into the intrinsic value formula mentioned above, we get the following:

$11.89 x 1.12^5 x 15.4  $323

This formula tells us that the intrinsic value of AAPL 5 years from now is approximately $323.

So how do we determine what Apple is worth today? Simple, we use discounting to arrive at the Net Present Value of this future value (read the links if you are unfamiliar with these terms). We will use a 10% discount rate, which is approximately equal to the long term historical return of the stock market. This is the minimum rate of return you would have to earn to justify stock picking over investing in an index fund. 

$323 / 1.10^5  $201

There it is; according to our simple but effective intrinsic value formula, AAPL is currently worth $201, while it is trading at $204 at the time of writing. In other words: AAPL is currently fairly valued. Only when the estimated intrinsic value is way above the current share price should you consider buying a stock.

And remember that valuing a company is more art than science, in that there is no perfect way to do it, it will always be an estimate, not an absolute. Therefore it is recommended to use multiple valuation methods and then compare the results to get a better idea of the true value of a company.

I wrote a FREE ebook titled "How to Value Stocks", which describes 3 intrinsic value models in detail. Interested? Then leave your name and email in the form below to receive it in your inbox straight away!

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