Intrinsic value vs market value refers to the difference between where a stock is trading and where it ought to be according to its fundamentals. The term “market value” simply refers to the current market price of a security. Intrinsic value represents the price at which investors believe the security should be trading at. Intrinsic value is also known as “fair market value” or simply “fair value.”
According to Merriam-Webster dictionary, the word “intrinsic” means “belonging to the essential nature or constitution of a thing.” At times, stocks become overbought or oversold, meaning their market price can rise above or below their intrinsic value.
When it comes to value vs. growth stocks, value investors look for companies that are out of favor and below their intrinsic value. The idea is that sooner or later stocks return to their intrinsic value.
What Is Market Value?
In a sense, there is only one measure of market value: what price the market assigns to a stock, based on existing demand.
Market value tends to be influenced by public sentiment and macroeconomic factors. Fear and greed are the primary emotions that drive markets. During a stock market crash, for example, fear may grip investors and the market value of many stocks could fall well below their fair market values.
News headlines can drive stock prices above or below their intrinsic value. After reading an earnings report that’s positive, investors may pile into a stock. Even though better-than-expected earnings might increase the intrinsic value of a stock to a certain degree, investors can get greedy in the short-term and create overextended gains in the stock price.
The rationale behind value vs price, and behind value investing as a whole, is that stocks tend to overshoot their fair market value to the upside or the downside.
When this leads to a stock being oversold, the idea is that investors could take advantage of the buying opportunity. It’s assumed that the stock will then eventually rise to its intrinsic value.
What Is Intrinsic Value?
The factors that can be used to determine intrinsic value are related to the fundamental operations of a company. It can be tricky to figure how to evaluate a stock. Depending on which factors they examine and how they interpret them, analysts can come to different conclusions about the intrinsic value of a stock.
It’s not easy to come to a reasonable estimation of a company’s valuation. Some of the variables involved have no direct physical, measurable counterpart, like intangible assets. Intangible assets include things like copyrights, patents, reputation, consumer loyalty, and so on. Analysts come to their own conclusions when trying to assign a value to these assets.
Tangible assets include things like cash reserves, corporate bonds, equipment, land, manufacturing capacity, etc. These tend to be easier to value because they can be assigned a numerical value in dollar terms. Things like the company’s business plan, financial statements, and balance sheet have a tangible aspect in that they are objective documents.
Calculating Intrinsic Value vs Market Value
There can be multiple different ways to determine the intrinsic value of an asset. These methods are broadly referred to as valuation methods, or using fundamental analysis on stocks or other securities. The methods vary according to the type of asset and how an investor chooses to look at that asset.
Calculating Intrinsic Value
For dividend-yielding stocks, for example, the dividend discount model provides a mathematical formula that aims to find the intrinsic value of a stock based on its dividend growth over a certain period of time. Here is what is a dividend: periodic income given to shareholders by a company.
Upon calculating the dividend discount model, an investor could then compare the answer to the current market value of a stock. If market value were to be lower, then the stock could be seen as undervalued and a good buy. If market value were to be higher, then the stock could be seen as overvalued and not worth buying or possibly an opportunity to sell short.
Another method for estimating intrinsic value is discounted cash flow analysis. This method attempts to determine the value of an investment in terms of its projected future cash flows.
While the dividend discount model and discounted cash flow analysis can be seen as objective ways to determine a stock’s value, they also have a large subjective component. Analysts must choose a timeframe to use in their model. Using different timeframes can lead to different conclusions.
Longer timeframes are often thought of as being more accurate because they include more data points. But they could also dilute the significance of more recent trends.
Example Using Dividend Discount Model
For example, if a company had years of steady dividend growth, but recently slashed its dividend by 50%, a dividend discount model analysis based on a long timeframe would show this reduction in dividend payments to be less severe than an analysis based on a shorter time frame.
The longer timeframe would include previous years of dividend growth, which would theoretically outweigh the recent reduction.
The reduction may have come from a large decrease in earnings. If that trend were to continue, the company could be doomed to the point of having to suspend its dividends (as many companies did in 2020). So in this hypothetical example, a shorter time frame could actually lead to a more realistic conclusion than a longer one.
Calculating Market Value
The determination of market value is rather simple by comparison. Someone can either simply look at what price a stock is trading at or calculate its current market capitalization. The formula for market capitalization or market cap is:
Total number of outstanding shares multiplied by the current stock price.
Dividing market cap by number of shares also leads to the current stock price.
Sometimes companies engage in “corporate stock buybacks,” whereby they purchase their own shares, which reduces the total number of shares available on the market.
This increases the price of a stock without any fundamental, tangible change taking place. Value investors might say that stocks pumped up by share buybacks are overvalued. This process can lead to extreme valuations in stocks, as can extended periods of market euphoria.
Using the intrinsic value vs market value method is best suited to a long-term buy-and-hold strategy.
Stock prices can remain elevated or depressed for long periods of time depending on market conditions. Even if an investor’s analysis is spot on, there’s no way to know for sure exactly when any stock will return to its intrinsic value.
Value investors try to understand stock volatility, using these periods as opportunities for rebalancing their portfolios, selling positions that might have increased a lot while adding to positions that may have fallen far below their intrinsic value. This contrasts to short-term day trading strategies or momentum swing-trading, which primarily uses technical analysis to try and predict and profit from short-term market fluctuations.
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