Question

What does it mean if the market price of a company is lower than its intrinsic value? Explain with examples.

Answer 1

Intrinsic value by definition, points to the value of the company in the absence of external factors. It is the worth of the company derived out of itself. Companies can derive their worth from the projects they have undertaken, which generates cash flow, the assets they have invested in, etc. For example, the discounted cash flow method is a widely used method where a company's intrinsic value is arrived at from projected free cash flows it would generate. This does not take into account market perception, market sentiments, etc. in the value.

On the other hand market price is the price at which buyers and sellers agree to trade at the moment. This takes into consideration a lot of external factors, such as market sentiments, perception of the business, etc.

When the market price is lower than the intrinsic value of the company, we say the stocks are available cheap. This is because market perception does not affect the long term cash-generating ability of the company.

Suppose, we arrive at a valuation of $50 per share for Company A through DCF method, and the stock currently trades at $40 per share, we say the stock is underpriced. In other words, we can say the market is yet to truly value the earning potential of the company.