The magnitude of profit, reaped from any investment mainly depends upon the price at which the product is bought. If a product is bought at a price, which is less than the intrinsic value, then chances of making profit is very high. But, if the price, at which the product is purchased, is much more than intrinsic value, then the chances of losing money is high. All the great investors around the world have the capability of finding out the intrinsic value of the product. So, if you want to reap profits from your investments then you need to have the ability to find the intrinsic value of the business.
WHAT IS INTRINSIC VALUE?
Intrinsic value is the perceived or calculated value of a product, which takes into consideration all the tangible and intangible assets associated, using different methods. It is also referred to as the true value of the product. Intrinsic value used in options pricing indicates that the option is in the money. It plays a very important role in the concept of value investing, by providing good stocks at a discounted price.
INTRINSIC VALUE OF A STOCK:
Just like every product, stock has its own intrinsic value. A fundamentally strong stock having current market value less than its intrinsic value is an option for value investing. In stock market there are many such strong fundamental stocks which trade below their intrinsic. There are many reasons due to which a stock goes below its intrinsic value. The reasons can be issues related to corporate governance, change of CEO, negative news, loss of order and many others. If someone buys these stocks and hold patiently, they will definitely help them make good money.
CALCULATING INTRINSIC VALUE OF A STOCK:
There are four very popular ways of calculating intrinsic value of a stock.
1. DIVIDEND DISCOUNT MODEL:
This model works on the principle, “cash is king”. The extra cash that a company has, after meeting all its expenses, goes to the investor in form of dividends. This formula helps the investors in identifying future high dividend stocks and also the intrinsic value of any stock.
2. GORDON GROWTH MODEL:
This model assumes that the company is in consideration of growing dividends regularly.
3. RESIDUAL INCOME MODEL:
4. DISCOUNTED CASH FLOW:
This is the most commonly used valuation method.
WHY INTRINSIC VALUE IS IMPORTANT?
The above given methods are used by the investors or analysts to determine intrinsic value of a stock. After the value is known, it helps them to categorise the stock as overvalued or undervalued. This also gives them the opportunity of making low risk investments, as the undervalued stocks have already shred their costly valuation. So, the chance of them shredding more price, is low. According to research reports if money is invested in undervalued stocks, the return obtained is much more than the investment made in good overvalued stocks.
For a beginner, starting his/her investment journey, it becomes very important to know the concept of intrinsic value. According to Warren Buffet, “It is better to buy a good business at cheap valuation, than buying an excellent business at a costly valuation”. In stock market having patience is very important. So, wait for the price to come down. It definitely will come down, that’s how the stock market works.
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