Key Valuation Models and Intrinsic Value in Fundamental Analysis

What is Intrinsic Value?

Intrinsic value refers to the true worth of a company based on its fundamentals, not its current market price. It considers:

• • Future cash flows
  • Growth prospects
  • Risk factors
  • Competitive position

If the intrinsic value of a stock is higher than its current market price, the stock may be undervalued and present a buying opportunity.

Key Valuation Models Used in Fundamental Analysis

Let’s explore the most widely used valuation methods to determine intrinsic value.

1. Discounted Cash Flow (DCF) Model

The DCF model estimates the present value of a company’s expected future cash flows. It involves:

• • Projecting free cash flows for future years
  • Choosing a discount rate (usually WACC)
  • Calculating terminal value
  • Discounting all future cash flows to the present

Formula:
Intrinsic Value=∑FCFt(1+r)t+TV(1+r)n\text{Intrinsic Value} = \sum \frac{FCF_t}{(1 + r)^t} + \frac{TV}{(1 + r)^n}Intrinsic Value=∑(1+r)tFCFt​​+(1+r)nTV​

Where:

• • FCF = Free Cash Flow
  • r = Discount Rate
  • TV = Terminal Value
  • n = Number of years

Best For:
Mature companies with predictable cash flows (e.g., Apple, Coca-Cola)

2. Price-to-Earnings (P/E) Based Valuation

This is a relative valuation method comparing a company’s current P/E ratio to:

• • Its historical P/E
  • Industry peers
  • Market average

Formula:
$\text{Intrinsic Value}=\text{EPS}\times \text{Target P/E}$

Best For:
Profitable companies with consistent earnings

3. Price-to-Book (P/B) Ratio

P/B ratio compares a company’s market value to its book value (net assets).

Formula:
P/B Ratio=Market PriceBook Value per Share\text{P/B Ratio} = \frac{\text{Market Price}}{\text{Book Value per Share}}P/B Ratio=Book Value per ShareMarket Price​

Used primarily for financial or asset-heavy companies.

Dividend Discount Model (DDM)

DDM is used for companies that pay regular dividends.

Formula:
Intrinsic Value=D1r−g\text{Intrinsic Value} = \frac{D_1}{r – g}Intrinsic Value=r−gD1​​

Where:

• • D₁ = Expected dividend next year
  • r = Required rate of return
  • g = Dividend growth rate

Best For:
Stable, dividend-paying companies like utilities or mature blue chips

5. Enterprise Value (EV) Multiples

These models compare EV/EBITDA, EV/Sales, etc., to assess value relative to earnings or revenue.

Best For:
Companies with different capital structures or no net income yet

Why Intrinsic Value Matters

• • Helps avoid overpaying for hype-driven stocks
  • Identifies undervalued opportunities
  • Encourages long-term investment thinking
  • Acts as a margin of safety guide

Common Mistakes to Avoid in Valuation

• • Overly optimistic growth projections
  • Using inappropriate discount rates
  • Ignoring industry-specific factors
  • Relying solely on one model

Always cross-verify using multiple models and compare results for better accuracy.

Real-World Example: DCF Valuation of Company X

• • Projected FCF (next 5 years): ₹100 Cr growing at 8%
  • Discount Rate: 10%
  • Terminal Growth Rate: 3%
  • Calculated Intrinsic Value: ₹1,250/share
  • Market Price: ₹950/share → Undervalued

Summary Table of Valuation Models

Final Thoughts on Key Valuation Models and Intrinsic Value

Key valuation models and intrinsic value serve as a compass for value investors. While no model is perfect, combining several approaches can offer clarity and a stronger foundation for decision-making. Always remember: “Price is what you pay. Value is what you get.”