How to find the Intrinsic Value of a Stock?
Updated: Jul 2, 2020
Intrinsic value is the "fair" value of any stock. The concept of Intrinsic Value was first introduced by Benjamin Graham in his book The Intelligent Investor which is considered to be the bible of value investing.
In this article, I will tell you how to find the intrinsic value of a stock and how we can use this information to invest in stocks?
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So, let's get right into it.
Benjamin Graham was a British-born American Economist, Investor, and Professor who developed the principle of intrinsic value which is the cornerstone of value investing. According to him, one must buy stocks that are available at a discount to their intrinsic value.
What does he mean by discount?
Well, suppose a stock's intrinsic value is Rs 100 and the stock is currently trading at Rs 40 in the market. Then the stock is trading at a discount of 60% from its "fair" value or intrinsic value.
INTRINSIC VALUE FORMULA
To calculate the intrinsic value of stock Graham developed a formula which is known as the Graham formula.
The formula takes into account the company's EPS i.e Earning per share and the expected growth rate of the company for the next 5-7 years. The formula looks like this:
V = EPS x (8.5 + 2g)
V = Intrinsic Value
EPS = Earning per share
g = Assumed future growth rate
In 1962, Graham updated the above formula to make it more relevant for future use. What he did is that he inserted a "multiplying factor" in the factor. The multiplying factor is called the interest rate factor. The new formula looked something like this:
4.4 = Interest rate of AAA Corporate Bonds in the USA in the Year 1962
Y = Interest Rate of AAA Corporate Bonds in the USA as on today
GRAHAM FORMULA UPDATED FOR INDIA
The above formula has many limitations from the perspective of Indian Stocks. In the formula, there is a factor of "4.4". This makes it suitable for stocks in the USA. There must be a different factor for Indian stocks, right? Why?
Because in the denominator there is a factor of “Y”. "Y" is the Interest rate of AAA corporate bonds operating in a country (for us it is India). Hence, the numerator must also be tweaked for India.
For Indian stocks, I believe we should use India AAA corporate bond yield in 1962 and for Y we should use bond yield for today. The problem here is that we don't have India AAA corporate bond yield for 1962. So I thought to use the below assumption.
Hence the revised Graham’s intrinsic value formula looks like this:
Using the above formula let's try to calculate the intrinsic value of Reliance Industries.
The first thing we need is the EPS:
We can find the EPS of every listed stock from screener.in. On screener, the EPS of Reliance Industries for FY20 ending is given to be Rs 58.2.
Next, we need the expected or assumed growth rate. I consider the historic 5-7 years compounded revenue growth rate as the expected growth rate. This figure can also be found on screener below the Profit&loss table. For RIL it is around 9%.
Applying the formula for Intrinsic value in an excel file and considering the following assumptions:
EPS = 58.2
g = 9.74%
Y = 6.84%
We get the Intrinsic value of Reliance Industries stock coming out to be Rs 640.81.
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Benjamin Graham’s intrinsic value formula is only a starting point of stock valuation. It can only give a rough idea of the intrinsic value of a stock. But one must not base their decision on this formula alone.
MUST-READ: How to start investing in Stocks?
Note: DGM Capital is an Investment Banking and Wealth Management Firm providing its clients with services like Investment advisory, Wealth Management, Algorithmic trading, and M&A Advisory.