Watch our video on how to use an intrinsic value calculator.
Do you know what an intrinsic value calculator is? Let alone how to use one? It's a nifty tool you can use to learn to true value of a stock.
Intrinsic value refers to an investor's perception of the inherent value of an asset, such as a company, stock, option, or real estate.
Ideally, once calculated it should show you if the value of a company is higher or lower than the current market value. And with this information you can calculate the risk you’ll be exposed to if you buy.
This number is extremely useful for value investors whose goal is to buy stocks and other investments at a discount to this amount.
I don’t know about you, but I like to get a bargain. Some of my friends call me cheap, but I like to refer to myself as frugal, and there’s a difference.
The most recent example of this happened yesterday. My friend just came home from the hair salon with a new bottle of “miracle” shampoo that promises to add volume and shine. Yeah okay. And wait for it, this 300 ml bottle cost $25.
Perhaps it was the look on my face that said it all. But why would you pay $25 for a bottle of shampoo that you can buy at the local drug store for maybe $10?
I’m assuming it was the name or the flashy bottle. I’m a girl; I get it. I like nice things, but I still can’t wrap my head around why anyone would overpay for anything that is so blatantly obviously overpriced. Help me understand.
The same goes for buying stocks. Who’s guilty of buying stocks based on a hot tip or the fact that the product is flashy?
I guess what I’m getting at is that you need to figure out what constitutes value before you drop coin on something that’s no better than drug store shampoo. That's where an intrinsic value calculator comes in.
If you didn’t already know, value investors try to find stocks that are trading for less than their intrinsic value. The general idea is to buy a stock for less than its worth, simple as that. In other words, the goal is to buy cheap stocks not cheap looking stocks.
Now, this is where things get a bit tricky as there's no one set in stone way of evaluating a stock's intrinsic value.
One would say that intrinsic value is subjective; two investors can form two completely different -and equally valid, opinions of the intrinsic value of the same stock.
In the examples below, you will see a few different methods of the intrinsic value calcualtor used depending on the asset being assessed.
Different assets require different methods to calculate their intrinsic value. Take options for example. Calculating intrinsic value is easy.
You simply take the difference between the stock's current price and the option's strike price, then multiply by the number of shares your options entitle you to buy. Hence your intrinsic value calculator.
Intrinsic Value (options) = (Stock Price - Strike Price) * Number of Options
Say American Airlines (AAL) is trading for $35 a share. You own four call options that entitle you to buy the shares at a cost of $30.
So, the intrinsic value of your options is equal to the difference between the stock price ($35) and the strike price ($30) which is $5. Next, you multiply the difference ($5) by the number of options (4*100 shares = 400 shares).
In this case, the intrinsic value of the option is $2,000 and we refer to this as an “in the money” options. You can calculate this using the intrinsic value calculator or formula above.
On the flip side, options that are not "in the money," have a strike price greater than the current share price. These options have no intrinsic value and are trading only for time value.
Unfortunately, when it comes to stocks, calculating intrinsic value isn't so straight forward. Some people feel that intrinsic value is the present value of the business’ future cash flows.
Others believe it is all the available facts that determine value. Therefore, an intrinsic value calculator may be necessary.
What’s more, there are multiple calculation methods used depending on the person doing the calculation. Basically there three different methods used to calculate intrinsic value:
There's a difference between buying cheap stocks and buying stocks for less than they’re truly worth. And this is the core concept of value investing; buy cheap stocks, not cheap looking stocks.
The majority of the time, when a stock is trading for below-average book value, sales or multiple of earnings, it’s for a reason. Your job is to find that reason and act accordingly on your findings.
The company could be having problems - think mismanagement or the industry may be in upheaval. It wasn’t too long ago that we had trade wars between the US and China with sanctions and tariffs imposed.
This hurts companies, especially those that rely on the smooth flow of goods with minimal cost. Check out our live trade room to see how we trade during potential economic trouble.
Fortunately or unfortunately, depending on how you look at it, there’s no shortage of cheap-looking stocks on the market. One particular sector rife with them is the retail sector.
With the rise of e-commerce, the fall of big-box stores has come as no surprise. And with this fall comes the fall in retail stock prices; many trading at near single-digit numbers.
Take the iconic retail store Sears. After 125 years in business, they had to file for bankruptcy. Now let’s look at Macy’s; last summer it was trading at $40 and is now at $25.
This may look like a bargain but it is only truly a bargain if it has a future. How does a store like Macy’s which depends on 40% gross margins and heavy advertising survive in a world where sales are moving online?
For those gamers out there, GameStop (NYSE:GME) is another example of a stock that looks like a bargain but probably isn't. In 2017, shares traded for just 6 times the previous year's earnings.
Just this past year alone, price plummet from $17 to $8. I’d suffice to say GameStop's main business of selling physical video games has a short future once the major game console makers go solely digital. This is because PC went digital long ago, and it's only a matter of time before consoles follow suit.
In response to the changing market, GameStop is trying to adapt by selling electronics and collectibles. And rest assured, when you fast-forward ten years, the way the company makes money will be completely different from how it does now.
What does that mean to you? Well if you value the stock based on earning from a line of business that isn't likely to be around in ten years, you might as well go buy that bottle of expensive shampoo.
The bottom line here, the intrinsic value of any stock depends on the company's future, not just it's present. Don’t get trapped! Try our swing trade room free for 14 days.
My one tip: all "value stocks" are not created equal. If the only reason you're buying a stock is because of low valuation, chances are you're making a mistake.
Unless of course, the price is so low that nearly any scenario leads to profits. Remember, most cheap stocks are cheap for a reason.
So it's your job to find out why so you can capitalize on the true value stocks. You’re only as good as the stocks you trade.
If you're ready to begin your investing journey, check out Bullish Bears to get started today.
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