Intrinsic Value vs Market Price

Intrinsic Value vs Market Price | CFA Level I Equity Investments

In this lesson, we’ll explore the difference between the intrinsic value of a stock and its market price, as well as the challenges of using such an approach.

Intrinsic Value: The Fundamental Value of a Stock

In the topic on market efficiency, we learned that the intrinsic value of a company stock is the value assigned by rational investors if they had a complete understanding of the stock’s characteristics. The intrinsic value is also known as the fundamental value because it’s based on the firm’s fundamentals and characteristics. An analyst uses these inputs in their valuation model, along with their assumptions, to estimate the intrinsic value.

By doing this, the analyst is implicitly stating that the market is inefficient and that abnormal profits can be made by trading to profit when the market price converges towards the intrinsic value. If the estimated intrinsic value is lower than the market price, the stock is overvalued, and the investor should sell or short the stock. If the intrinsic value is higher, the stock is undervalued, and the investor should buy the stock. If the two values are equal, the stock is fairly valued, and no abnormal profit is expected.

Keep in mind that this is just one analyst’s estimate of the real intrinsic value of the stock, which is unknown. Every analyst has a different model and assumptions, so each analyst’s intrinsic value is likely to be different.

Five Considerations for Investors

For the investor, there are a number of considerations when deciding whether to act on an analyst’s estimate of the intrinsic value:

  1. Percentage difference between the market price and the estimate: Small differences are to be expected, and the expected profit is so small that it is not worth taking on the risk. If the difference is large, the expected profit may be worth taking the risk for.
  2. Confidence in the valuation model used: There are several ways of valuing a stock. The investor should question if the valuation model used by the analyst is appropriate for the company’s line of business.
  3. Confidence in the analyst’s assumptions: One common assumption is the projected growth rate of the company, and some models are extremely sensitive to this. For example, a tiny 0.1% increase in the growth rate can perhaps increase the estimated intrinsic value by 3%. An investor would want to be quite sure that the analyst’s estimates are reliable before taking a position in the stock.
  4. Explaining the mispricing: Markets are fairly efficient, so mispricings should be negligible. If there’s a large mispricing with no satisfactory reason, there could be something wrong with the analyst’s estimates, or insiders could be trading on material information that hasn’t been made public yet.
  5. Belief that the market price will move toward the intrinsic value: The investor must believe that the market price will actually move toward the estimated intrinsic value and that it will do so to a significant extent within the investment time horizon. Even if the estimate is spot on, the investor won’t profit if the market price doesn’t move toward it.

These are the five considerations an investor has to make when deciding whether to act on an analyst’s estimate of the intrinsic value. By taking these factors into account, investors can make informed decisions about whether to buy, sell, or hold a particular stock based on the estimated intrinsic value.

In our next lesson, we’ll provide an overview of the three major types of valuation models used by analysts.

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