How can you find the Intrinsic Value of a Stock?
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?
Read the original article here.
So, let’s get right into it.
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)
Here:
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:
here:
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:
CONCLUSION
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.
Note: DGM Capital is an Investment Banking and Wealth Management Firm in India, providing its clients with services like Investment advisory, Wealth Management, Algorithmic trading, and M&A Advisory in India.