Intrinsic Value vs Market Value, Explained
The term market value refers to the current market price of a security. Intrinsic value represents the price at which investors believe the security should be trading, based on company fundamentals.
When it comes to value vs. growth stocks, value investors look for companies that are out of favor and below their intrinsic value. The idea is that sooner or later stocks return to their intrinsic value. A deeper understanding of intrinsic value vs. market value may help your strategy.
What Is Market Value?
In a sense, there is only one measure of market value: the price the market assigns to a stock, based on existing demand.
Market value tends to be influenced by public sentiment and macroeconomic factors. Fear and greed are the primary emotions that drive markets. During a stock market crash, for example, fear may grip investors and the market value of many stocks could fall well below their fair market values.
News headlines can drive stock prices above or below their intrinsic value. After reading a company’s annual report that’s positive, investors may pile into a stock. Even though better-than-expected earnings might increase the intrinsic value of a stock to a certain degree, investors can get greedy in the short-term and create overextended gains in the stock price.
The rationale behind value vs. price, and behind value investing as a whole, is that stocks tend to overshoot their fair market value to the upside or the downside.
When this leads to a stock being oversold, the idea is that investors could take advantage of the buying opportunity. It’s assumed that the stock will then eventually rise to its intrinsic value, and could be sold at a profit.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
What Is Intrinsic Value?
It can be tricky to figure out how to evaluate a stock. Analysts can come to different conclusions about the intrinsic value of a stock, depending on which factors they examine, and how they interpret them. The factors that can be used to determine intrinsic value are related to the fundamental operations of a company.
Some assets can be considered intangible because they have no physical, measurable value — but they impact a company’s performance and bottom line. Intangible assets include things like copyrights, patents, company reputation, consumer loyalty, and so on.
Tangible assets include things like cash reserves, corporate bonds, equipment, land, manufacturing capacity, etc. These tend to be easier to value because they can be assigned a dollar value.
💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.
Calculating Intrinsic Value vs Market Value
There can be multiple different ways to determine the intrinsic value of an asset. These methods are broadly referred to as valuation methods, or using fundamental analysis on stocks or other securities.
How Intrinsic Value Is Different
Using fundamental measures to assess share price — such as cash flow, assets vs. liabilities, and earnings — enables investors to get a sense of a stock’s inherent value versus relying on market sentiment, which can drive the price of an asset above or below its fundamental value.
It depends on the investor’s view. There are different philosophies about what determines value vs. price, and whether a stock can even be considered overvalued relative to its intrinsic worth.
• Efficient market adherents argue that the market has already priced in all information into the security’s price, which makes it hard to view a security as over- or undervalued.
• Technical analysts believe that the future value of a stock can be determined by a careful reading of trading patterns and price charts, and are less interested in intrinsic factors.
• Momentum investors similarly focus on price trends, and buy and sell according to market sentiment (without factoring in possible intrinsic value factors).
By contrast, an intrinsic value strategy would argue that fear and greed can influence the market price of any security, and that knowing the fundamentals gives a far more accurate picture of the value of a stock versus its price.
Recommended: How to Analyze a Stock
How to Calculate Intrinsic Value
Intrinsic value investors rely on certain measures like free cash flow (which indicates that a company has enough cash to invest in its priorities), as well as its price-to-book (P/B) ratio and price-to-earnings (P/E) ratio.
• The P/B ratio helps investors assess whether the company value (based on share price) is above or below total assets.
• The P/E ratio represents the company’s share price divided by the company’s earnings per share, and indicates whether the price reflects earnings.
Intrinsic investors may also consider earnings reports, interest rate fluctuations, economic indicators, as well as market trends when evaluating a stock.
Overall, though, evaluating free cash flow is essential to calculating intrinsic value. For this reason the Discounted Cash Flow (DCF) model is commonly used by intrinsic investors.
The Dividend Discount Model
For dividend-yielding stocks, for example, the dividend discount model provides a mathematical formula that aims to find the intrinsic value of a stock based on its dividend growth over a certain period of time. Dividends are periodic payouts given to shareholders by a company.
Upon calculating the dividend discount, an investor could then compare it to the current market value of a stock.
• If the market value was lower, then the stock could be seen as undervalued and a good buy.
• If the market value was higher, then the stock could be seen as overvalued and not worth buying or possibly an opportunity to sell short.
Another method for estimating intrinsic value is discounted cash flow analysis. This method attempts to determine the value of an investment in terms of its projected future cash flows.
While the dividend discount model and discounted cash flow analysis can be seen as objective ways to determine a stock’s value, they also have a large subjective component. Analysts must choose a timeframe to use in their model. Using different timeframes can lead to different conclusions.
Longer timeframes are often thought of as being more accurate because they include more data points. But they could also dilute the significance of more recent trends.
Example Using Dividend Discount Model
For example, if a company had years of steady dividend growth, but recently slashed its dividend by 50%, a dividend discount model analysis based on a long timeframe would show this reduction in dividend payments to be less severe than an analysis based on a shorter time frame.
The longer timeframe would include previous years of dividend growth, which would theoretically outweigh the recent reduction.
The reduction may have come from a large decrease in earnings. If that trend were to continue, the company could be doomed to the point of having to suspend its dividends. So in this hypothetical example, a shorter time frame could actually lead to a more realistic conclusion than a longer one.
Calculating Market Value
The determination of market value is rather simple by comparison. Someone can either simply look at what price a stock is trading at or calculate its current market capitalization.
The formula for market capitalization or market cap is:
Total number of outstanding shares multiplied by the current stock price.
Dividing market cap by number of shares also leads to the current stock price.
Sometimes companies engage in corporate stock buybacks, whereby they purchase their own shares, which reduces the total number of shares available on the market.
This increases the price of a stock without any fundamental, tangible change taking place. Value investors might say that stocks pumped up by share buybacks are overvalued. This process can lead to extreme valuations in stocks, as can extended periods of market euphoria.
The Takeaway
Intrinsic value and market value describe the value of a security as it’s currently trading versus where its underlying fundamentals suggest it should be trading. Using the intrinsic value vs market value method is likely best suited to a long-term buy-and-hold strategy.
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FAQ
What’s the difference between fair value and market value?
Fair value is the estimate of a company’s intrinsic value, whereas market value reflects the actual market price of company shares. While they may be used interchangeably, the two terms are different.
What if intrinsic value is higher than market price?
When an investor or analyst determines that the intrinsic value of a stock is higher than the market price, that could indicate the stock is undervalued. Value investors typically seek out such stocks, believing their price could rise over time to match the true value.
Why is it hard to calculate intrinsic value?
Intrinsic value is a more complex calculus, and can vary depending on the factors someone chooses to evaluate. This is partly because intrinsic value includes the dollar value of tangible assets, cash flow, liabilities, and so on — as well as intangible assets like patents, copy rights, brand reputation, and so forth.
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