The intrinsic value of stocks is the measure of how much particular stocks are actually worth as opposed to what their market price may be. This is an important concept for investors, because it may allow them to identify bargains on the market and take advantage accordingly. In truth, the intrinsic value of stocks may be measured many different ways, and it often depends on the individual strategy preferred by the investor. Most methods involve metrics like earnings per share and also take into account expected future performance, while at the same time including the concept of margin of safety, which refers to the amount of slack an investor needs between intrinsic value and market price before buying the stock.
In many cases, the market price of a stock may actually be misleading about the actual worth of the stock. It may give a good reading on the current situation of the underlying company or business, but it might not take into account its potential in the future. For that reason, investors try to devise ways to determine the intrinsic value of stocks, which gives an idea of how much they are truly worth.
One simple way of determining the intrinsic value of stocks is to use the earnings per share of the company and measure it against a discount rate. The discount rate would be the percentage rate yield of a sure-thing investment like a government bond. For example, a stock earns $3 US Dollars (USD) per share and is measured against a discount rate of a government bond yielding 5 percent return. By dividing 0.05 into $3 USD, an intrinsic value of $60 USD per share is reached.
This is the simplest method of calculating the intrinsic value of stocks, and it yields a number that can be compared to the current price to determine if the stock is undervalued or overpriced. For example, if that stock from the example above had a current price of $45 USD per share, then it would represent a bargain. Using expected earnings per share for future years can give an investor an idea of the stock's potential.
Since no method for calculating the intrinsic value of stocks is totally accurate all of the time due to intangible factors, investors often stick to a margin of safety when using intrinsic value. This represents the percentage difference between intrinsic value and market price that the investor prefers before following up on his or her calculations. For example, an investor who prefers a margin of safety of 50 percent targets a stock that he or she determines to have an intrinsic value of $50 USD per share. Fifty percent of $50 USD is $25 USD, which means the investor prefers that the market price of the stock be at $25 USD per share or lower before buying.
