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3 Ways of Calculating a Stock's Intrinsic Value

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

How is a stock's intrinsic value calculated, anyway?

How is a stock's intrinsic value calculated, anyway?

Valuation 101

If you're a value investor, you've certainly internalized the concept of intrinsic value, the idea that you can pin down what a company is really worth with a number, which may not be very correlated to the price at which the stock is selling. The general idea is that most stocks will eventually revert to their intrinsic value at some point, so if you buy a stock when it's well below this number, you're very likely to pick up a market return bonus, as Mr. Market suddenly realizes he has valued this business far too cheaply.

Conversely, you'd prefer not to buy a stock selling above its intrinsic value since even with great earnings and cash flows, the company's stock is likely to decline in the future so that the price eventually reverts to intrinsic value. Intrinsic value is what all of the cash flows a company will ever produce are worth today, and here's a primer on the gist of how to value a company in case you're still getting a handle on this idea.

However, even if you're dialing in this idea, it can be really difficult to come up with an exact number for intrinsic value. In fact, as the old saying goes, it is far better to be approximately right than precisely wrong, using a range of different probability-weighted scenarios in order to improve your ability to get a range of numbers. Here, we'll take a look at just how to do that.

Start With Your Base Case

The first thing to do here is to take a look at three possible scenarios for the business you're trying to value. You're probably inclined to think about what's called the base case scenario first, and it's exactly what it sounds like. Given the most likely inputs, the base case spells out how you see things going if everything unfolds mostly as you expect. This means considering not only the fundamentals of the business itself but also how the market is likely to value the business at some point in the future.

It's not wise to try to time the markets (many more have gone broke trying than have made money!), but you can often get a sense of where things stand today, and you can use that to inform whether you think interest rates might go up or down, or whether climate change might affect how much oil is consumed in 30 years, or whether a company's products are likely to be adopted. This base case gives you a middle ground, and it's an excellent starting point, but stopping with just one scenario can limit your ability to have a fuller picture of how the future might go. Let's improve this.


Bulls and Bears

Once you have a base case scenario, you need to consider two additional scenarios. First, consider what it might look like if things go wrong. Think about a future where the company's product or service isn't as widely adopted as previously thought, or regulatory concerns keep them from getting to market.

What about if interest rates rise? If the company uses a lot of leverage, this could be a really, really bad indicator of their ability to raise capital and could prove really destructive. Do they have a moat, and is it possible that the moat might degrade over time? Think about things that might go wrong for the stock, and you have your bear case.

Invert this thinking, and you can consider whether your company has any positive tailwinds (internal or external factors that might aid in the company's ascent). Consider a scenario where things generally go a little better than expected for the stock. Perhaps Mr. Market will no longer assign such a low P/E, or maybe the company will earn a little more than analysts are projecting. Perhaps a law will pass that makes doing business easier for the company, or maybe a new discovery will be widely adopted and will allow them to do business in areas they weren't able to reach before. This is your bull case.

Probability Weighting

Once you have your three scenarios plotted out (bear, bull, and base), it's time to consider how likely each scenario is in your imperfect judgment. Think about how likely you consider everything that went into your bull case scenario to unfold, including all the macro stuff, and if you're buying, try to be a little conservative here (if you're not sure whether the bull case is 10% likely or 20% likely, lean toward 10%).

Similarly, ask yourself how likely the bull and base cases are to unfold, or at least how similar to those projections the future is likely to be. It's highly probable that reality will unfold somewhere in between your bull and base case scenarios or between bear and base, and that's okay: we are not trying to be precise here but instead get a sort of range.

Assuming you have a stock selling at $100 today, with the following scenarios plotted out, you can make a valuation like so:

  • Base case: 50% probability of $150 intrinsic value
  • Bear case: 25% probability of $50 intrinsic value
  • Bull case: 25% probability of $400 intrinsic value

In the above scenarios, we've laid out three cases for how the future might go, along with corresponding values and percentages. This becomes a pretty simple math problem to solve: just multiply each probability by each value, then add the numbers up. When you do that, you get an intrinsic value of $187.50. It's important to note that this final number is considerably higher than your original base case number, and that's because this stock has an asymmetric upside.

A stock has this when the amount of likely losses in a bear case scenario is much lower than its likely gains under a bull case scenario when you weigh the probabilities. If you can lose $50 a share by a sharp decline, but the stock still has value (maybe you could sell the assets, or maybe the business would continue to run anyway), your downside is limited considerably. On the other hand, there can often be fewer limitations on the upside.

Go Forth and Lay Waste to the Market

Using a more conservative bull case, along with a somewhat more morbid bear case, can help augment your margin of safety, but even with all of this, you still need to lean heavily into a margin of safety, especially on the buy side. However, you can get a really good idea of how one stock stacks up against another by getting one probability-weighted number for each; whichever stock is the most undervalued is the one you buy.

Assuming you've already limited your universe of stocks to stuff you feel comfortable investing in, all of the businesses you're considering are going to already be in your wheelhouse, so whichever company has the best value is the one to buy today, all things being equal. Portfolio allocation will determine whether you're using a bottom-up or top-down approach, but regardless, you should always consider intrinsic value when buying or selling, and using three scenarios can help you get a more informed idea of how much a stock is worth.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Andrew Smith