Successful long term investors consider the intrinsic value of stock before buying and when deciding to sell. This approach to stock investing goes back to the black days following the 1929 stock market crash which ushered in the Great Depression. Benjamin Graham taught investors that they did not need to play the market as though they were picking numbers on the roulette wheel. Rather he taught investors to do fundamental analysis of stocks in search of forward looking earnings. At the same time investors learned to consider what features of a stock provided a safety net in times of trouble. This was the margin of safety that some stocks have in the form of money in the bank, unencumbered property, or products that are unassailable in their market niche. Successful stock investing became a matter of thoughtful analysis and not a matter of guess work.
What Is the Intrinsic Value of Stock?
Think of intrinsic stock value as the fundamental value of the stock. Analyze the stock to determine its price based on predicted future income and then subtract the current stock price. Calculate expected company cash flow and then discount to current dollars. Determining intrinsic value of stock is a discounted cash flow valuation. The key to determining intrinsic value of stock is getting a clear idea of the medium and long term prospects of the business in question. Successful stock investors learn to judge how well a company will manage its assets, products, costs, R&D, and marketing. When the picture is clear an investor can make an informed decision. If the market price is less than the intrinsic value of stock it is time to buy and if one owns the stock and the prices are reversed it is time to sell.
A Formula for Calculating Intrinsic Value of Stock
Here is the original formula that Benjamin Graham suggested as modified in 1962 and again in 1974.
- Preceding twelve months earnings per share, EPS
- A constant of 8.5 representing an expected price to earnings ratio, P/E ratio, for a company that is not growing
- g being an estimate of long term growth (five years)
- A constant = 4.4, the average yield of high grade corporate bonds in the early 1960 decade
- Y = The current yield of AAA corporate bonds
- V = intrinsic value
The formula is as follows:
V = (EPS x (8.5 + 2g) x 4.4)/Y
Once the investor had determined the intrinsic value of a stock he compares that number to the current market price. Intrinsic value divided by current price is referred to as the Relative Graham Value or RGV. An RGV of more than one indicates a buy and an RGV of less than one indicates that one should ignore the stock or sell if it is already in one’s portfolio.
Practical Daily Use of Intrinsic Value Stock
One needs to adjust the 4.4 value in the equation for current treasury yields. In addition one needs to use a crystal ball to determine when the Fed will cut back on its stimulus program which will send treasury rates up. Inflation is accounted for in the equation by way of treasury yields. To the extent that the Fed becomes far more influential in driving inflation to avoid deflation, devaluing the USD to promote exports, or other politically motivated acts intrinsic value of stock may be more difficult to predict. Nevertheless this is still a valid concept and along with finding the margin of safety of a stock helps long term investors make rational decisions in buying and selling stocks.