How to Calculate Intrinsic Value to Find Undervalued Stocks

Value investing is getting the most reward from your stock market investment and you need to follow some simple steps to accomplish that.

The first thing you must know is how to value a stock by calculating its intrinsic value. In this article, I will dive into 3 simple steps that you can follow to implement your value investing strategy.

More...

start your investment

There are three things to consider for making great value investment:

· Identifying the value companies

· Buying stocks when they are undervalued

· Selling them when their price recovers or they become overvalued

These three things are the essentials for value investing. Valuing a stock should always start with the three points mentioned above. You need to first find companies that represent great value and are safe to invest in.

Secondly, you need to buy the stocks from that company when they are undervalued. There are numerous reasons why a stock will become undervalued, which we will explore later.

Thirdly, to get the most reward from your stock investments you need to sell them when their value recovers to its true value or it even becomes overvalued. This is how you make a profit from your stock market investments.

Valuing a stock should always be your first step before you make any investment and these three essentials are key to understanding how to value a stock.

3 Steps to Use Intrinsic Value to Find Undervalued Stocks

In the last section, we mentioned there are three things you must look for if you want to make a solid value investment. In this section, we are going to explore each of those steps in detail.

Find Undervalued & Financially Strong Stocks

Find undervalued stocks

The first step in value investing always begins with identifying fundamentally strong businesses to invest in.

These companies offer the best value for investors and there are different fundamental variables that demonstrate this. These companies are called value companies and they have the following characteristics:

· A competitive advantage over their competitors

· Are consistently growing in net income and cash flow

· Have low debt

· Are operated by a strong and responsive management team

The first thing you need to look at when performing your assessment is looking at their competitive advantage over their competitors. There are different things that can give a business a competitive edge in the marketplace.

Overall, if a business has a competitive advantage it means it has something or does something that is superior to its competitors, which is a major contributor to its strong sales.

The second thing to explore is whether the business has consistently grown in net income and cash flow throughout history.

This is where a fundamental analysis of the company’s growth is essential. Quite often, you can find these growth reports from the company themselves.

If the company has consistently grown over a long period of time, but also recovered well after a downturn then it's likely they'll keep growing in the future.

A major contributor is low debts. If the company has grown each year while keeping their debts low then they are a strong company.

The management is also important to look at. You want to look at how often a company changes its board and higher-level management.

The strongest companies will have the fewest amounts of changeovers in upper level and CEO management positions.

Businesses that demonstrate every characteristic above are the one’s you should place on a watch list because they offer the greatest chance of value stocks.

Find Intrinsic Value Using The Intrinsic Value Formula

Buying stocks from a fundamentally strong company, when they are undervalued is crucial to value investing. The key to value investing is being able to buy stocks from fundamentally strong companies. However, you only want to buy stocks from this company at certain times.

calculate a stock's intrinsic value

Buying stocks when the company is performing well means, you will probably pay a lot of money for that investment and it’s not necessarily the best stocks to invest in.

Instead, the way you get great value from your stock investment is to buy the stocks when they are undervalued. It may seem counterintuitive to do this; in fact, this is where many beginners fail with their investing.

They will buy stocks from a strong company but start selling them when they are underperforming. That is the worst strategy because undervalued stocks from a fundamentally strong company are the best to buy.

A company’s stock can become undervalued for various reasons. One reason is bad PR, this will affect the company in the short term, but eventually they’ll bounce back.

It could be because of some errors in judgement from the company’s board in running the business, which has caused a downturn in the company’s stock.

Other reasons are the market. For example, when there is a recession all companies are going to be affected. Other times, there may be specific industries that struggle for reasons specific to their industry.

However, this is always the best time to buy a stock. If you did your fundamental analysis from the previous section properly, you’ll know your company has a strong history of growth. Therefore, you know that it will eventually bounce back and recover to its intrinsic value.

It’s when this happens that the fun begins for you as a value investor.

Of course, calculating intrinsic value is time consuming and it requires a lot of work. That’s why I created this great Intrinsic Value Formula infographic for you.

It contains all the formulas that you can use to calculate your stock’s intrinsic value.

formula for calculating intrinsic value

You can learn more about how to calculate intrinsic value of a stock here. This is one of the best stock valuation guides that we have published on Wealthy Education.

After knowing your stock's intrinsic value, it's time to make your investment decision.

​You can buy a stock when it's currently undervalued, and then sell it later for profits - that's exactly what value investing is about 🙂

Selling The Stock When It Reaches Closer to Its Intrinsic Value

sell a stock when it becomes overvalued

We’ve mentioned buying undervalued stocks from a fundamentally strong business with a proven history of growth and performance.

A business’ stock will often become undervalued because of bad public news, problems in senior management or the market itself.

Whenever these negative events occur, a business’ stock will become undervalued and this is the best time to buy them.

However, because this company is fundamentally strong and has a solid history of growth we know that their stock price will eventually recover.

Reasons for a stock’s recovery are varied but are usually due to either good public news about the company, a return to consistent net sales or a change in management that has resulted in a boost for the company’s profits.

It’s also important to not forget the market because the market also plays a huge role. If the market is down it will always eventually recover and this will make the company’s stock surge in price.

Once the stock price recovers, this is the best time to sell because they will either return to their true value or even experience a surge in price. There is a simple strategy you need to remember regarding buying and selling value stocks, “Buy low, and sell high.”

A key in being able to make value stock investments is knowing how to read the stock market so you need to become a student and expert of the stock market.

You need to know when there is going to be a dip and anticipate if a company’s stock is about to fall because of recent negative PR.

Pay attention to these kinds of things because it plays a significant role in being able to read the stock market, and knowing when and from which companies to buy and sell stocks.

The Bottom Line

Value investing is one of the most secure and safest ways to begin investing in the stock market and start making inroads to creating a solid future for yourself financially.

The key to a solid value investing strategy is to make sure you first locate fundamentally strong businesses, buy their stocks when they are undervalued and then sell them when they become overvalued.

If you want to apply the value investing strategy correctly, you must learn how to find a stock’s intrinsic value. Once you know the value that it’s actually worth, you can make your investment decision at ease.

About the Author

This is a guest post contributed by Hung Nguyen – Co-Founder of Wealthy Education. Since 2014, he has helped over 10,000 students from over 140 countries learn stock investing and discover a life of financial independence. You can also find him on Twitter, Pinterest, and Facebook.

Related posts

Leave a Comment