Calculating a Stock’s Intrinsic Value
This calculator can be used to determine the intrinsic value of a common stock, or equity, which is a technique pioneered by Benjamin Graham about one hundred years ago. The calculator needs a total of nine inputs, including:
- The current market price per share of the equity being analyzed
- The company’s free cash flow, as found on the statement of cash flows. If necessary, the values can be in thousands
- The expected growth rate of those cash flows. Oftentimes an estimate of the earnings per share growth rate is substituted for the free cash flow growth rate. This calculator splits the growth rate into three different time dimensions
- The discount rate to be used when finding the present value of the free cash flows. The discount rate should be risk adjusted – more on this topic later
- The total number of outstanding shares of stock
- The company’s total outstanding debt
- The desired margin of safety
The calculator then provides the user with four outputs:
- The present value of the free cash flows
- The intrinsic value of the stock being analyzed
- The intrinsic value of the stock when considering the margin of safety
- The actual margin of safety at the current market price per share
Why Calculate Intrinsic Value?
Calculating the intrinsic value of a security is one of the ways to determine if the price of a security is reasonable. Since the calculation involves both fundamental and technical analysis, the intrinsic value of a security should be considered an estimate of value. Why this is so will be clearer as we dive into each of the calculation’s inputs.
Known Variables used to Calculate Intrinsic Value
There are several variables used in the calculation of intrinsic value that are indisputable. This list includes the total debt outstanding, which can be found on the company’s balance sheet, the current price per share, and the current number of shares outstanding.
Technical Analysis and Intrinsic Value
No doubt the calculating intrinsic value is part art and science. We have a set of known variables, but we also need to take some educated guesses too. The formula relies on discounted cash flows. That means we need to “guess” what might happen in the future. While it’s easy enough to find a value for free cash flow on the company’s statement of cash flows. That value rises or falls over time as the company makes new investments.
Free cash flow is the starting point for the projections of all future cash flows, so the analyst should spend some time determining the right value to use in their analysis. This leads us to the next set of variables – growth rates. Our calculator allows for three sets of grow rates. First, we have growth that occurs in the near term, over the next five years. Next, we have a set of longer-term growth assumptions in years six through ten. Finally, we have what is referred to as the terminal growth rate. This value is used in all years after ten.
The calculation of intrinsic value relies on a discounted cash flow approach, that means we also need to estimate a discount rate. Typically, discount rates increase with risk. Since we are talking about common stocks, one starting point might be the average long-term return of the S&P 500 – which is around 11%. We can also augment that value by the stock’s beta – which is a measure of the equity’s risk relative to the market. For example, if a stock’s beta is 0.9, then a discount rate of 11% x 0.9, or 9.9% might be appropriate when valuing that security.
Finding Variable to Use when Determining Intrinsic Value
The best source of freely-available information required to determine intrinsic value is Yahoo Finance. Looking at the Statistics tab for a security, you’ll find the stock’s beta, free cash flow, shares outstanding, and total debt. On the Analysis tab, you can also find out what analysts believe is a reasonable growth rate over the next five years.
Intrinsic Value Example: Microsoft
The default values used for this calculator were those for Microsoft in September of 2022. The current selling price was around $154 per share and the starting point for all the other variables were obtained from Yahoo Finance. In terms of the growth rate, we took the expected growth rate over the next five years and roughly halved it in years six through ten, then halved it again for our terminal growth rate. In terms of the discount rate, we chose 8%, rather than using value closer to 11% x 0.94 (Microsoft’s beta), or 10.3%. Note that increasing the discount rate would have decreased the value of intrinsic value. Alternatively, we could have input more reasonable values (higher values) for Microsoft’s growth rates. The idea here is to understand the sensitivity of the inputs to determine what might be a reasonable estimate of the stock’s intrinsic value. As previously mentioned, the inputs for intrinsic value are part art and science.