Stocks have intrinsic value

Ever wonder why one stock sells at Rs 250 and another sells at Rs 1000? These prices are decided by who? This is the section we'll be discussing - what is intrinsic worth?

We learned about technical analysis tools and techniques and how to use them in the last section. Let's take a moment to compare technical analysis with fundamental analysis. Here is where the intrinsic value of stocks enters play. This figure is the pivot point of technical analysis.

WHAT IS THE INTRINSIC VALUE?
The intrinsic value of a stock refers to its true value. This value is determined based on the future monetary benefits you expect to get from the stock. It is the highest value you can purchase the asset at, without losing it in the future. We will examine this further, before you start to wonder what this all means.

WHAT IS THE INTRINSIC VALUE?
Technical analysis can help you predict the price movement and possible price levels. The stock's intrinsic value is what determines the price. Technical analysis can only help determine the direction and extent of stock price movements.

Prices must start somewhere before they can move in a certain direction. Let's assume that the stock price is currently Rs 150. It will rise to Rs 175, according to your technical analysis. But where did the price of Rs 150 get its current value? It is possible to calculate it.

Let's take the house that you are considering buying. This apartment is rented out for rent. What would you pay to get it?

Let's say you plan to keep it for ten more years. It is unlikely that you would want to pay more than what you can earn. This is the sum of the rent you have earned over 10 years and the potential sale price. This would be the flat's intrinsic value.

This value has been adjusted to account for inflation and other risks in order to ensure accuracy. This will be discussed in detail later in this section. This method is also known as the present value model or the discounted cashflow model. This model can also be used to calculate the intrinsic value of stock.

The conclusion is that the intrinsic value of a stock represents the potential future earnings.

HOW IS INTRINSIC VALE OF STOCKS CACULATED?
It can be calculated using either the present value or relative value methods.

PRESENT-VALUE METHOD:
As we have seen, the expected future income can be used to calculate the intrinsic value of a residential property. Similar methods can be used for equity shares. What is the expected future income for shares? The company will offer you a share of its annual income if you invest in stocks. This is known as a dividend. You also receive money when you sell your share, much like the apartment. The intrinsic value of your share is calculated by adding the value of dividends to the future selling price (called terminal worth) of the share.

But there's one caveat. Is a dividend of Rs 100 that you receive today equal to Rs 100 that you receive after 10 years? It is unlikely! The value of Rs 100 after ten years is lower than that of the same amount today. In other words, inflation causes money to lose value over time. You can't buy the same goods and services today for Rs 1,000 as five years ago. Right? This is the time value money.

You will need to adjust for the change in value by discounting each future dividend. You will first divide the future dividends at a certain rate before adding them together. To calculate the intrinsic value, you add up all of these values. These are the steps required to estimate the present value.

You can also use this method to calculate the intrinsic worth of a stock company. The intrinsic value of a stock can be calculated by combining EPS and PE. The intrinsic value of your stock will be calculated by multiplying the average PE of competitors (23) with your company's EPS (5). This will give you Rs 115. Your stock should be purchased at Rs 115. It is a bargain, as it is available on the market at Rs 100. It is possible to buy it, and it will appreciate to this fair price.

The relative value approach is important because it takes into account both the company's fundamentals and market trends in order to calculate an intrinsic stock price. Although it is more realistic, this approach can have flaws. Your intrinsic value estimate could be invalidated if fundamentals change significantly in the future.

RELATIVE METHOD FOR VALUE METHOD:
Let's now move on to the second way of calculating intrinsic value for stocks. This involves comparing the stock's price with one of the company’s fundamentals.
 

As you will recall from the fundamental analysis chapters, a financial fundamental is a key financial figure drawn from the financial statements of a company. The key fundamentals include sales revenue, net income (also known as earnings), and book value of equity share. You own a part of the fundamentals when you purchase shares in a company. You can earn a percentage of the company's profits or sales revenues, for example. Because you own shares, you are a part owner of the company.

Logically, you want to purchase at the lowest price possible. You will pay less to buy each unit of fundamentals if the share price is lower than the market.

Let's take a look at an example. The price to earnings (PE), one of the most useful ratios for relative value analysis, is an example. This ratio compares the company's per-share price with its per-share earnings. The PE is 20 if the price per share of the company is Rs 100 and its earnings (EPS) are Rs 5. This means that you will pay Rs 20 for every rupee of earnings from the company.

How can you tell if the price is fair. This can be done by comparing the PEs of competitors to the company. Your shares will be cheaper if the PE average of the competitors is, for example, 23. You will pay an average of Rs 23 per unit for a share in the earnings of a competitor. Your company will only have to pay Rs 20. This is the reason why relative value is used.

WHY INTRINSIC VALUE CAN NOT BE PREFERRED IN TECHNICAL ANALYSIS
We've already discussed in great detail the virtues intrinsic value and fundamental analysis. Let's now play the devil's advocate.

Technical analysts disapprove of the notion of intrinsic value, despite its many benefits. Technical analysts believe future market trends cannot be predicted accurately by looking at past price movements. Intrinsic value-based investment is

INTRINSIC MAY BE UNSTABLE:
The company's current fundamentals are used to calculate intrinsic value. Future fundamentals are an estimate that you make based on your calculations. This is a hypothetical number. This is not reliable. These fundamentals may be significantly altered by future events.

Sales may rise dramatically if, for example, the economy improves or if a company buys another company. This could lead to an increase of its intrinsic value. These possibilities are not possible to factor into intrinsic value calculations. These possibilities can only be predicted by technical analysis.

INTRINSIC-VALUE ESTIMATION IS IMPOSSIBLE FOR ALL ASSETS CODES :
The only problem with the intrinsic value approach to asset allocation is its inability to be applied to all asset classes. Stocks have fundamentals like future dividends, sales revenues, and earnings. The intrinsic value approach is possible. Markets can also trade in commodities, metals, and currencies.

These fundamentals are difficult to estimate. How can you project future earnings and dividends if you are investing in gold? It is not a company. It does not earn income or pay dividends. For estimating the value of such assets, technical analysis is required.

MARKET VALUE MAY NOT APPROACH INTRINSIC VALUE SOMETIMES :
Fundamental analysis also has a flaw: prices might not appreciate enough in the future to equal intrinsic value. In our previous illustration, we assumed that the stock was currently priced at Rs 100. It could appreciate up to Rs 115, according to your relative value analysis.

This will only occur if other investors in market think like yours. Only then can they all invest in the stock, thereby making it more valuable. But other investors might not think the same way as you. Stocks of smaller companies are more risky than stocks that are larger. These stocks could never rise despite their potential.

Even though your analysis is accurate, this will prevent you from making any money. This flaw is not present in technical analysis. Because it relies on historical trends in stock demand and supply patterns, technical analysis is free from this flaw. These are more realistic.