The Intrinsic Value Formula for Stocks

Submitted by Stock Market News on 22 April, 2011 - 00:18

Learn how to calculate the intrinsic value

Stock market trading is a big risk. No matter what your trading capital is money lost is still money lost. So before you buy any stock it’s always important to know if it’s worth your hard earned cash. The problem is with a variety of stocks and the uncertainty of the stock market, its not easy to pull out the good ones from the bad. Fortunately there are ways to find out if a stock has potential.

Intrinsic Value

It doesn’t mean that a stock with a cheap price will yield big returns later on, so you need to calculate the stock’s worth. This is intrinsic value. Calculating the stocks however will depend on what fundamentals you want to consider. Each trader has their own criteria of what makes a good stock and how to evaluate it. After picking a stock that you think has a good prospect, ask yourself what are your expectations. After this, you can now proceed to use a valuation technique to calculate if the purchase is acceptable and if it will yield your expected profits.

Some Points to Ponder:

  • What is your investment horizon?
  • What is your risk profile?
  • What is your expected price to earnings ratio?
  • What is your expected dividend payout?
  • What is your expected rate of return (ROI)?

Step one

First you need to calculate its share price depending on your investment horizon and expected stock growth. Let’s say you want a timeframe of ten years, and you expect that during this time the stock will grow by ten percent. You project the stock price for the next the ten years using 10 percent per year growth.

Forecast stock price in 2021= EPS (earnings per share) after 10th year x Average PER (price to earnings ratio)

Step two

You have to calculate the total value of the stock in the future, from 2011 to 2021. You also have to include the dividend. Some investors may not take dividends into account but it does have an effect on the total future value.

Total dividends= total EPS (earnings per share) x Average Dividend Output

Future Value (@2021) = Forecast Stock Price in 2021 + Total Dividends

Stage three

Now you can calculate the stock’s intrinsic value with what all the figures you have so far.

Intrinsic Value = Net Present Value = Future Value /Expected ROI(10) (rate of return by 10 years)

Final Step

After getting the intrinsic value you compare it to the current stock price. If the current stock price is below the intrinsic value then it is acceptable.

The most important part in calculating for intrinsic value is to have realistic expectations. Furthermore you have to assess your risk profile to determine your rate of return. The rate of return on the other hand must suit your needs and trading strategies. Warren Buffett believes in intrinsic value, but make sure that the same method works for you before following his footsteps.

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