How Intrinsic Value Is Calculated in a Screener: The Key to Smart Investments

But before we get too technical, let’s make one thing clear: intrinsic value isn’t something that can be found by glancing at a company’s stock price or a few key financial ratios. Instead, it’s about figuring out what a company is really worth at its core—without the noise of market fluctuations. Why does this matter? Because the market’s price for a stock isn’t always correct, especially in the short term. But intrinsic value—based on fundamentals—doesn't lie. Once you understand how to calculate it, you're ahead of the game.

The Real Question: Why Should You Care About Intrinsic Value?

Let’s cut to the chase: knowing the intrinsic value can make the difference between buying a stock that skyrockets over time and one that stagnates or declines. It’s the key to smart, long-term investments.

Think about Warren Buffett, one of the most famous investors of all time. He consistently talks about intrinsic value as a cornerstone of his investment strategy. He looks for companies that are trading at a price lower than their intrinsic value, essentially buying a dollar for fifty cents. This allows him to invest in strong companies while minimizing risk.

Here’s Where It Gets Interesting: Intrinsic Value vs. Market Price

You might be wondering, "What’s the big deal? The market price should reflect the company's worth, right?" Wrong. Market prices are subject to emotions, news, and short-term events. In contrast, intrinsic value focuses on the true worth of the business. It strips away all the outside noise to focus on fundamentals like earnings, dividends, and growth potential.

But here’s the twist: calculating intrinsic value isn’t simple, and there are several models to approach it. Below, we’ll dive into how to calculate intrinsic value using one of the most popular methods—the Discounted Cash Flow (DCF) model.

Step 1: Understanding the Discounted Cash Flow (DCF) Model

The DCF model is based on the premise that a company’s value is equal to the present value of its future cash flows. In simpler terms, it means you’re estimating how much money the company will generate in the future and then "discounting" it back to today’s dollars, using a discount rate. This gives you an idea of how much the company is really worth right now.

Here’s a basic formula for the DCF model:

Where:

• CF = Cash Flow for each future year
• r = Discount rate (usually the company’s weighted average cost of capital or WACC)
• n = Number of years in the future

In plain English, this means you're calculating the present value of each year's expected cash flow and then adding them up.

Why the Discount Rate Matters

The discount rate is key because it adjusts for risk and opportunity cost. The higher the discount rate, the less a company’s future cash flows are worth today, implying that the company is riskier or that investors could earn a better return elsewhere. The lower the discount rate, the more the company’s future cash flows are worth today, suggesting less risk or lower returns in alternative investments.

Step 2: Forecasting Future Cash Flows

Now that we understand the formula, the next step is estimating the future cash flows. This isn’t easy and requires an understanding of the company’s operations, industry trends, and financial statements. You’ll need to look at:

• Revenue Growth Rates: How fast is the company growing its sales?
• Profit Margins: Are they improving over time, or are they shrinking due to competition or rising costs?
• Capital Expenditures (CapEx): How much money does the company need to spend to maintain or grow its operations?

Once you have a projection for future cash flows, you plug them into the DCF formula and calculate the total intrinsic value.

Step 3: Calculating the Terminal Value

Since it’s impractical to estimate cash flows indefinitely, we typically stop forecasting after a certain number of years and calculate what’s known as the "terminal value"—the value of all future cash flows beyond the forecast period.

There are several ways to calculate the terminal value, but one common method is using the Gordon Growth Model, which assumes that the company will grow at a constant rate forever. The formula looks like this:

Where:

• CF_{n+1} = Cash flow in the first year after the forecast period
• r = Discount rate
• g = Growth rate

Step 4: Adding It All Up

Once you have the present value of the forecasted cash flows and the terminal value, you simply add them together. This gives you the intrinsic value of the company. If the market price of the stock is below this value, you’ve potentially found a bargain. If it’s above, the stock may be overvalued.

Other Methods of Calculating Intrinsic Value

While the DCF model is popular, it’s not the only way to calculate intrinsic value. Other models include:

• Dividend Discount Model (DDM): Focuses on the present value of future dividends, best suited for companies with stable dividend payouts.
• Earnings Power Value (EPV): Based on a company’s ability to generate earnings, regardless of future growth.
• Asset-Based Valuation: Calculates intrinsic value by looking at the net assets of the company, which can be useful for asset-heavy businesses.

Challenges and Criticisms

No method is perfect, and each has its drawbacks. For instance, the DCF model relies heavily on assumptions about future growth and the discount rate. If your estimates are off, your intrinsic value calculation will be too. Similarly, the Dividend Discount Model assumes stable dividend growth, which may not apply to all companies.

Key Takeaways

Here’s what you need to remember:

• Intrinsic value is the true worth of a company, based on its fundamentals, not market price.
• The Discounted Cash Flow model is a common way to calculate intrinsic value by estimating future cash flows and discounting them back to present value.
• The discount rate plays a crucial role in adjusting for risk and opportunity cost.
• Different models can be used to calculate intrinsic value, each with its own strengths and weaknesses.

In the world of stock screeners, knowing how to calculate intrinsic value gives you a powerful tool. It allows you to cut through the market noise and identify companies that are truly undervalued. And when you can do that, you're investing like the pros.