How to Use Intrinsic Valuation to Compare Stocks Effectively

Often, stock market investing is like walking in the dark. How can an investor determine the value of a stock when there are thousands of companies to choose from and the market price is frequently erratic due to news, sentiment, and speculation? 

The secret to comprehending is to focus on the company’s worth rather than just a stock’s market price. A company’s intrinsic value is determined by its true worth rather than by the price at which its stock is trading.

Knowing how to compute and apply intrinsic value will enable you to assess stocks expertly, seize possible deals, and make investments based on factors that add actual financial value rather than merely speculation. 

In this blog post, we will look at the key models for intrinsic value, how to apply them so that stocks can be compared effectively, and what to monitor so that your analysis is reliable.

Let’s begin!

Key Takeaways

• Understanding the foundational models for calculating intrinsic value 
• Exploring valuation models for comparative analysis 
• Decoding the critical role of them 
• Looking at the things beyond numbers 

Foundational Models for Calculating Intrinsic Value.

For an intrinsic valuation, there is more than one formula. Each of its many models provides a unique viewpoint on a company’s worth. The most widely recognized approach is a company’s ability to produce cash flow for its shareholders.

This approach focuses primarily on the DCF model. The DCF valuation’s basic idea is straightforward. A company’s worth is the total amount of money it will make in the future. Each of those future cash flows is “discounted” back to its present-day value. We need to discount future cash flow because a dollar today is worth more than a dollar tomorrow, owing to inflation and investment opportunity cost. 

 A DCF analysis forecasts a company’s free cash flows (FCF) for a certain period of time, usually 5 – 10 years, and produces a terminal value that estimates all cash flows after this period. They apply a discounting factor to the figures based on the risk profile of the investment, usually the Weighted Average Cost of Capital (WACC).

Another key method is the Dividend Discount Model (DDM). This model works best for established companies that are paying regular dividends. A stock’s value is assumed to be equal to the present value of all future dividend payments by the model when determining its price. Despite being less complicated than a complete DCF analysis, the DDM is not very useful for businesses that reinvest their profits in expansion rather than paying dividends.

Last but not least, there’s the Residual Income Model that relies on figures.  It assesses the worth of a firm’s current net asset value as well as the discounted value of anticipated residual income. 

Residual Income is the net income earned by a company that is less a charge for the cost of equity capital. This method relates a firm’s value directly to its reported earnings and book value. Therefore, it serves as a valuable cross-check against cash-flow-based models.

Interesting facts
Value investors (like Warren Buffett) seek stocks where the calculated intrinsic value is higher than the current market price, suggesting the stock is undervalued and a potential buying opportunity.

Applying Valuation Models for Comparative Analysis.

Being aware of the models is one thing, but using them to compare stocks is quite another. To demonstrate which of these two businesses is the better investment at each company’s current price, we aim to conduct an “apples-to-apples” comparison.

Consistency is the first step. When comparing two or more companies (especially in the same industry), make sure your valuation models are based on the same assumptions. 

The forecast period must be the same (for example, 10 years for both), the terminal value must be calculated consistently, and the discount rate must be determined sensibly. For example, if you are comparing two tech companies, you may put a bit of a higher discount rate on the one with the more lumpy earnings to compensate for its higher risk.

Comparing the intrinsic value of each company’s shares with their current market price comes next. The comparison gives you the “margin of safety,” as renowned investor Benjamin Graham popularized. 

A stock is undervalued and has a lower risk of loss if it has a large margin of safety, which means that its intrinsic value is much higher than the market price. In this example, if company 

A has an intrinsic value of $150 per share and a market price of $100, this represents a 33% margin of safety. If Company B’s intrinsic value is $60 and its market price is $50, then its margin of safety is 17% only. All things considered, Company A seems to be a better bet.

Automated tools can significantly streamline this process. For example, platforms like alphaSpread perform sophisticated DCF and other valuation analyses on thousands of stocks, providing pre-calculated intrinsic values. 

Using a tool like this can help you quickly screen for undervalued companies and benchmark your own analysis. However, it’s still crucial to understand the underlying assumptions.

The Critical Role of Assumptions and Scenarios

The worth of the evaluation depends chiefly on the principles behind it. Your estimates for revenue growth, profit margins, and capital expenditures will have a direct impact on the ultimate intrinsic value. 

You will obtain an excessively high value if your conclusions are excessively optimistic. However, if you are overly negative, you may miss a good opportunity.

Analyses of scenarios and sensitivity are required to combat this. Instead of depending on a single set of assumptions, create three distinct scenarios.

1. Best-case scenario assumes still realistic growth-rate and margin improvement assumptions.
2. The base-case scenario uses your most realistic, well-researched estimates.
3. Models a downturn with lower growth and compressed margins. 

When you calculate the intrinsic value under each scenario, you are not estimating just one point; you are creating a range. All of the above gives you a more realistic picture of the possible outcome and the downside risk. 

You can feel even more confident about your choice when you know more about the investment’s potential downside value. In this level of analysis, platforms such as alphaSpread can be very helpful because they frequently automate scenario analysis based on past market trends and volatility..

Furthermore, your presumptions ought to be based on a thorough comprehension of business and its sector. Study the company’s competitive advantages, management quality, market position, and also the economic trends in its sector. 

This kind of qualitative research is as important as quantitative modeling. If you didn’t have the context, the numbers wouldn’t mean anything at all.  The alphaSpread platform, for example, takes qualitative factors into its analysis to obtain a deeper understanding of the long-term prospects of a company.

Beyond the Numbers: Qualitative Factors in Valuation

The tools for intrinsic valuation are provided by quantitative models, but they are not able to fully capture the situation. Qualitative factors are intangibles that can either present a risk or an opportunity for success. A common error made by people is to ignore them at their own risk.

One of the most crucial qualitative elements is management quality. Over time, a management that is knowledgeable, trustworthy, and supportive of shareholders can generate significant value. 

Selecting executives who have demonstrated success in the past, have a clear future vision, and have compensation linked to shareholders is a good idea. Reading annual reports and shareholder letters can teach you a lot.

The competitive edge of a company (also termed the economic moat) is yet another consideration. It is a sustainable advantage that protects a business from its competitors and allows it to maintain high returns on capital. 

There can be many moats such as brand (Coca-Cola), network (Meta Platforms), switching cost (Microsoft), and cost advantage (Walmart). A company with a broad and durable moat is capable of generating cash which has a high likelihood of continuing far into the future. 

This makes its intrinsic value higher and more certain. It’s complicated to factor in these elements but some analytical tools, like alphaSpread, try to assess the strength of a man’s moat.

Finally, consider industry trends and potential disruptors. Is the company operating in a growing or declining industry? Could its business plan be harmed by technology? 

A stock price of a company in a dying industry, no matter how cheap it appears, may potentially be a ‘value trap’ which is a stock that appears inexpensive and simply keeps on dropping in value over time. To avoid these traps, forward-looking analysis is a necessity.

Discipline Will Lead You to Better Investing

Comparing stocks with intrinsic valuation is powerful for every genuine investor. A company’s core capacity to generate cash and create value will always triumph over the cacophony of daily market swings, according to Schrager. Consistency is crucial to the process, as are careful analysis, ongoing application of frameworks such as the DCF, and self-compassion.

The secret is to combine qualitative understanding with quantitative rigor. Make sure your valuation models are always based on sound research. Construct scenarios with various possible outcomes. 

Always do these two things while not forgetting to assess the quality of management and the sustainability of the competitive advantage. When you determine a company’s true value and then demand a margin of safety, you equip yourself with the power to invest confidently, ascertain superior opportunities, and construct a sound money-making machine.