Intrinsic value calculation is essential for investors interested to buy stocks for long term. Intrinsic value calculation helps to estimate ‘true value’ of stocks. Share market is full of bad and good quality stocks. Long term investors loves to buy only quality ones. But quality stocks generally trade at overvalued price levels. One must always avoid to buy overvalued ones.
People must target only best shares to buy for investing. Buying only quality stocks which trade at undervalued price levels is the right strategy. Intrinsic value calculator is the key to success in stock investing. Identifying best shares to buy which are trading at undervalued price levels is a success mantra. But what are undervalued stocks?
Definition of undervalued stocks can better be understood by knowing intrinsic value. Some stocks trade at P/E ratios of 5. Others trade at outrageous P/E ratios of 40. Now the question remains, does high P/E ratio means stock is overvalued? Generally speaking, high P/E ratio hints at stock being overvalued. Then why investors still buy high P/E stocks? It is a also a general understanding that high P/E stocks are high growth stocks. But every thing in this world has a price. Even stocks has its right price. No matter how good are growth stocks, but if they are not bought at right prices, it will make loss. Stock fundamental may be great, but if not bought at right price loss is inevitable.
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Market price of stock shall be trading at prices below its intrinsic value. This is when stocks are said to be trading at right price. Stock trading at P/E of 30 can still be undervalued. Stock trading at P/E of 10 can still be overvalued. Intrinsic value calculator helps us to solve this investment puzzle. Best shares to buy will be those shares which is trading at discount to its intrinsic value.
Intrinsic Value Calculator
|Current Market Price (Rs.)|
|Current Year EPS (Rs.)|
|Expected Growth Rate (%) in next 5 Years|
|Interest rate of AAA Corporate Bond as on today (%)|
|Intrinsic Value (Rs.)|
When we go to the market to buy house hold items like groceries, clothes etc we see their price tag first. We know right price of house hold items, hence we make right decisions. Before we buy them we compare its current price with our right price. People who bargain are those who think that the right price are lower. Everyone does not carry the same numbers for ‘right price’ in their head. Right price differ form person to person. But this difference is not so big. If acceptable price of sugar is Rs40/Kg and a trader is selling it at Rs 45/Kg then he will face stiff resistance from public. The same buying logic applies to stocks as well. Target should be to to buy cheap stocks. Knowing the range of right price of stocks is essential. Let me give you an example:
Let me make a statement; “Stocks of TCS is trading at Rs 2,500 in Sensex”. What useful-information it provides to us? Does it say that it is a cheap stock? No. But if we know that ‘right price of TCS is Rs 2,600 and it is trading at Rs 2,500’ then this information is useful. It immediately highlights that TCS is undervalued. But in order to declare right price (intrinsic value) of TCS, I must know the skill of intrinsic value calculation. It helps us to identify cheap stocks
A person who does not know to value stocks will invest blindly. There is no other more reliable way of investing in stocks than value investing. Intrinsic value calculations based on stocks EPS are good. Not many in this world know how to value stocks. It is not difficult to develop at least basic stock valuation skills. But people ignore it as they prefer easier options. But easier options (like day trading) are less reliable. Long term investors always rely on intrinsic value calculation method.
Knowing intrinsic value of stocks in only the first step. Maintaining themargin of safety is also essential. Warren Buffett says that stocks must be bought by maintaining a margin of safety. Rule of margin of safety was first coined by Benjamin Graham. Stocks must be bought at market price equal to 2/3rd of its intrinsic value. Suppose a stock has intrinsic value of $300. Two-third of intrinsic value means 2/3 x $300 = $200. If market price of stock is $200 or below then it is a great buy. Intrinsic value calculation is only an estimate. Different experts has their own way of estimating intrinsic value. By maintaining a margin of safety we are adding a safety factor. This further prevents investors from making losses.
Note: Novice investors does not calculate intrinsic value of stocks, leave aside the intention to maintain margin of safety .
Calculate Intrinsic Value of Stocks (Stock Price Valuation):
- Step1 – Calculate intrinsic value of stock
- Step2 – Note the market price of stock
- Step3 – Compare current market price if it is trading below 2/3rd of its intrinsic value
Ben Graham value investing formula is one of the best stock valuation tools. Several decades ago Ben Graham wrote a book on value investing called Intelligent Investor. This book is still called as a bible of value investing. In this book Ben Graham proposed valye investing formula. Stock investors can use this formula to estimate the true value of stocks. Just to give you an idea of enormity of this value investing formula, I will give a brief introduction about Ben Graham. Perhaps we all know Warren Buffett, Ben Graham was the teacher and educator of Warrer Buffett. So a formula proposed by Ben Graham must be worth a fortune. Its true, this formula is really great yet simple to use formula. We cannot can say that the true value/intrinsic value estimated by this formula is perfect. But for an average investors like you and me, it will give us a very fair idea about true value of stocks.
Ben Graham Value Investing Formula
|EPS||Average EPS for the last 12 months (or one financial year)|
|8.5||Assumed P/E ratio of Stock|
|g||Assumed Growth Rate for the forthcoming years (7 to 10 years)|
But in this formula originally proposed by Benjamin Graham, the prevailing interest rate factor was not considered. In year 1962, Graham decided to update this formula. He inserted the interest rate factor in the existing formula. So the tweaked formula looked like this.
|4.4||Interest rate of AAA Corporate Bond in year 1962|
|Y||Interest rate of AAA Corporate Bond as on today|
You can get the AAA bond yield from the internet
Let us try to use this formula using a live example
I will use Ben Graham value investing formula to find true value of Tata Consulting Services share:
|Current Market Price||Rs 1,281.55|
g (Assumed Growth Rate )
|4% (I looked at growth in EPS for last five years)|
|EPS (Average EPS)||62.5 (I added last 4 quarter EPS)|
|Y (Corporate Bond Yield)||9.5%|
Taking all of these values and putting in Ben Graham value investing formula the result is like this:
V = 62.5 x (8.5+2×4) x (4.4/9.5) = Rs 478
TCS is currently trading at P/E multiples of 20 at market price of Rs 1281.55. So we can say that as per our value investing formula, TCS stocks are hugely overvalued (almost 2.6 times).
But if I see at its dividend yield, it is close to 1.95% which is not bad. So the conclusion that I can draw is this; defensive investors who does not have lot of interest in long term capital appreciation can go for TCS stocks. This will give them some dividend income. But in terms of growth, TCS is not so productive.
What I suggest to my reader is that Ben Graham value investing formula is only a starting point of stock valuation. It will give you an idea of the intrinsic value of a stock. But one must not buy stocks only on basis of this formula alone. Never use this formula in isolation as it will lead to errors. One must cross check true value of stocks using others tools like PEG and Earning Yields. One can also read my other article where I have described http://www.getmoneyrich.com/how-to-value-a-stock/how to value stocks. Use of the other rules to evaluate stocks and then using Ben Graham value investing formula can prove most profitable for investors.