As much as we would like to see an efficient market, we know that the idea looks good in theory but is barely feasible in real life. In the practical world, the more accurate behavioral finance outlook has replaced it.
The new-age theory believes that people rarely pay reasonable prices for acquiring an asset. It also states that markets do not usually indicate the actual state of the economy, and the pricing depends on a myriad of factors, such as demand and supply. It brings us to today’s topic – market value and intrinsic value of stocks.
These terms inadvertently help investors decide whether they want to go long or short, i.e., if they wish to invest in a stock or liquidate their holding.
This article discusses the market value and the intrinsic value of a share and would help you understand its role in investment decisions.
The market value of a share is the current price at which it is trading on a stock exchange. For example, a stock of State Bank of India (SBI) is currently trading at ₹ 432.50 on NSE (National Stock Exchange). It means that its market value is ₹ 432.50, or you will have to shell out ₹ 432.50 to buy a single stock of SBI.
The market value is the reflection of the public sentiment about a company. It is dependent on the demand and supply of the stock in the market. It has a positive relationship with demand, i.e., if there is a strong demand for a share in the market, its price will eventually rise. Whereas if the interest for it is sluggish, the price will move downwards.
The intrinsic value is the fundamental or the actual value of a stock. Unlike the market value, which is readily available, it is not as easily available to the public. Several tangible and intangible factors, such as market analysis, financial statements, and projected cash flows, determine the book value or the fundamental value of a share.
Also, the formula for calculating the intrinsic value varies from one analyst to another, and there are high chances of the results being different across the board. Also, at times, there is a certain level of estimation involved, making it more challenging for investors to reach the share’s intrinsic value.
Ways of Calculating the Intrinsic Value of a Share
Different schools of analysts have different ways to ascertain the intrinsic value of a share. While some believe that future projections should be the way forward, others believe that the current financial statements are appropriate for deciding the true value of a stock.
Those who believe in future projections being the right way employ cash flow discounting for their valuation process. Here, the estimated future cash flows attached to a share are pulled back using a rate of return to calculate the present intrinsic value.
Intrinsic value = CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n
CF = Expected Cash flow (CF1 is the expected cash flow for year 1, CF2 for year 2, and so on)
r = The Discount Rate
n = The number of years of projections
Some analysts believe intrinsic value is the book value per share (BVPS). An investor can obtain it by looking at the last released financial statements pertaining to the stock. In theoretical terms, it is the amount a company’s equity shareholders would receive if it goes into liquidation on the date of the last financial statements’ release.
Intrinsic value = (Total Equity – Preferred Equity)/ Total Outstanding Shares
Why Do Investors Use Intrinsic Value?
In theory, the market value of a share should be equal to its intrinsic value. But it barely takes place in reality. So intrinsic value acts as the benchmark for the investors to decide if the share is overpriced or underpriced. If the market value exceeds the fundamental value, the stock is overpriced. Whereas if the market value is below the intrinsic value, the share is underpriced.
Is there any term to describe the difference between the market value and the intrinsic value of a stock?
Real numbers often are a false representation of the price gap between the market value and the intrinsic value of a share. So we instead use a ratio, known as the price to book ratio, to gauge the difference accurately.
Price to book ratio = Market Value of the share/Intrinsic value of the share
The higher the price to book ratio is, the higher is the disparity. In an efficient market, the value of it should be 1.
It is one of the ways analysts determine the potential of a share. It is also compared with the ROE (return on equity) ratio to understand how efficiently the company uses its shareholders’ money to generate returns.
Which Is More Important?
Before undertaking any investment venture, analysing both market capitalisation value, as well as intrinsic figures, is crucial. While comprehensive technical analysing through market capitalisation helps you rule out all unsystematic risks of investment associated with a fluctuation of the stock market, fundamental analysis is required to understand the relative strength and potential of a company.
If you have a short-term investment regime in mind, go through stipulated technical analysis pointers carefully to identify and tackle any market risks associated with your portfolio. On the other hand, long-term investment requires an in-depth analysis of the fundamentals of a company, as it reflects the rate at which a business can grow, and thereby the rate of return on equity investment.
Analysis of the intrinsic value of a stock is crucial if you plan on pooling your money in lesser-known small and mid-cap companies, as investors often run the risk of falling into a value trap.
To Sum Up,
Understanding the significance of both market value and intrinsic value of a stock will help investors look into the same before undertaking any substantial investments. Though most people assume the stock market to be complicated and unpredictable, knowing which aspects to look for will help you rule out any unforeseen risks on total investment, ensuring high return generation.
So any investor looking to invest in a company’s shares must look into its market and intrinsic value to decide if the decision is financially viable.