Managers in a company are expected to understand the fundamentals of intrinsic value estimation. Primarily for the purpose of more competent managing techniques and executive actions since managerial decisions can inherently impact stock prices. In turn, this affects firm value in the long term. Furthermore, many executives are also stockholders and investors in their own businesses. Therefore, intrinsic value impacts not only the company evaluation but personal wealth and share value, which would also guide decision-making to a certain extent.
Companies can and often utilize intrinsic value as part of their financial policy. This includes the attractiveness of new investments and management of cash flow. It is beneficial for balance sheets, ensuring the stability of operations, and for evaluation of a competitive position from perspectives of earning power. Essentially, it is a simple tool that is proactively effective at managing the business and making judgments on financial security.
Evidently, intrinsic value is used to the major projection’s the company’s stock, including related aspects such as dividend payments or buyback of shares that can have prolonged impacts on operational, financial, and organizational structures of a business (Danielson, Heck, & Shaffer, 2015). Company value is vital to executives and owners who are engaged in important negotiations of merging or transfer of ownership interests.
A popular quantitative investment strategy currently being adopted is known as a value investment. It uses critical metrics and ratios to market prices in an effort to calculate the intrinsic value of the stocks or securities. Intrinsic value is considered a stable and reliable indicator that is based on a formulaic approach using fair business prices. An investor relies on intrinsic value to gain a comprehensive understanding of both the company and its stock projections. A value investor would use intrinsic value in a three-stage process. The discrepancy between price and intrinsic value should be identified. The intrinsic value of a stock is based on future earning potential.
Finally, the future earning power is formulated based on the analysis of both quantitative and qualitative factors (Kok, Ribando, & Sloan, 2017). The difference between the quoted sale price and intrinsic price provides a margin safety (expressed as a percentage of intrinsic value). In order to be included in the portfolio, the safety margins must amount to at least 20%, with the current sale price below the estimated intrinsic value by that percentage (Otuteye & Siddiquee, 2015).
Investors commonly utilize intrinsic value when conducting stock transactions. Particularly, intrinsic value serves as an indicator of sorts of when to sell stock. The general patterns indicate that investors attempt to “buy low,” and when the calculated intrinsic value is reached, the shares are sold for profit. However, this is a highly controversial use of intrinsic value as many other contexts are at play, and the market is not historically reliable and predictable.
However, it should be noted that true intrinsic value is reached when a stock has a price momentum on its side (Sather, 2017). This implies that a company’s growth may rapidly expand beyond the traditionally calculated intrinsic value, based on the indicators of FCF, DCF, and corporate valuation, which cannot predict trends or rapid growths commonly seen on the recent market. Overall, intrinsic value is a general and quantifiable analysis method for business evaluation, but it should be considered that there are external factors that should be left to an investor’s judgment and cannot necessarily be captured by value analysis.
References
Danielson, M. G., Heck, J. L., & Shaffer, D. (2015). Shareholder theory – How opponents and proponents both get it wrong. Journal of Applied Finance, 18(2), 1-5. Web.
Kok, U., Ribando, J., & Sloan, R. (2017). Facts about formulaic value investing. Financial Analysts Journal, 73(2), 81-99. Web.
Otuteye, E., & Siddiquee, M. (2015). Overcoming Cognitive Biases: A heuristic for making value investing decisions. Journal of Behavioral Finance, 16(2), 140-149. Web.
Sather, A. (2017). Value investors love to sell when reaching intrinsic value. Nasdaq. Web.