Understanding the Intrinsic value of a company and its corresponding market shares
In the digital age, buying and selling of shares can be done by anyone who knows their way around a computer, has an internet connection and access to an online trading platform like Robinhood, Plus500 or Trading 212.
Companies like Robinhood took online trading a step further by introducing zero commission trading. This attracted alot of retail investors, also known as non professional investors, because it meant they didn't have pay a commission when they sold or bought shares on a trading platform. Hence, the risk of associated with trading commissions were eliminated but the Systematic risks associated with trading remained.
Why are we talking about shares and trading? Put simply, most retail investors don't know the true worth of a company before buying their shares. Instead they rely only on historic trends of share prices and other factors to inform their decision to buy or sell a shares. While a lot of retail traders have made money this way, recent events like the alleged market manipulation of GameStop shares have shown that there are many cases when share prices don’t reflect the true value of a company.
There are two common techniques of calculating the value of a company. The first, is called market capitalisation, where a company's value is determined by multiplying the company's outstanding shares by the unit market price of its share. For example, if a company has a 100 outstanding shares and the current market price of each share is $2, the company's market capitalisation value is [100*2] = $200.
The second technique of calculating the value of a company is called the Net Asset Value method. This technique is more pragmatic because it relies on actual accounting numbers.
To calculate the company's value with this technique, you will need to the company's balance sheet as shown below. Identify their net assets and their net liability from the balance sheet. Then subtract the net liabilities from the net assets to calculate how much equity there is in the company. That becomes the company’s value. For example, if the balance sheet shows a net asset of $2000 and net liability of $1200. Equity = Asset - Liability = $800. Therefore the company is valued at $800.
When using the Market Capitalisation technique, you need to remember that the share market might take time to reflect the true value of a company. The speed at which share prices fluctuate makes it difficult to rely on such data as an indicator of a company’s worth. Meaning share prices could easily be over valued or under valued in the space of 5 mins.
So, how do you know if a share price is over valued or under valued? The answer lies in using a base line indicator called Intrinsic share value. Unlike your normal share value which is subject to market fluctuations , intrinsic share value is derived from the company’s balance sheet and calculated outstanding shares. To calculate the Intrinsic share value, you will need to calculate the company’s equity, and the number of outstanding shares in the company.
Intrinsic share value = (Net Asset - Net Liability)/ No. of outstanding shares
Once you have calculated your intrinsic share value, you compare this share value to the market share price.
If your share price is higher than your Intrinsic share value, that means the share price is over valued, so don’t buy, rather sell your your shares because you know the price is inflated and will come down sooner rather than later.
If the market share price is lower than the Intrinsic share value, then that means the share price is undervalued. So it is a good time for you to buy more shares while it’s cheaper because you know the share price will eventually go up to reflect it’s true value.
For example, you calculated the Intrinsic share value to be $3.8 per share but the market share price Is $6. Your decision should be “don’t buy” because the market price will eventually come down to the intrinsic share value and you will lose money. But if the market share price was $2 per share, your decision would be to buy more shares because you know the share price will go up to match the Intrinsic share value eventually.
There are scenarios where the market share price is equal to the intrinsic share value. In such a scenario your decision could be “do nothing“. That is, don’t buy or sell.
The downside of using the Net Asset Value approach to determine the value of a company's shares.
The NAV approach utilises the company's balance sheet to estimate the value of a company and its corresponding shares. Balance sheets are notoriously poor at capturing the value of a company's intangible assets. When calculating the value of a company, never make the mistake of ignoring the value of intangible assets within the company.
Intangible assets such as organisational knowledge, skillset, brand recognition, goodwill, trademarks, copyrights and intellectual properties are extremely difficult to capture on a balance sheet but also represent a large portion of the company's value.
Another intangible asset that is difficult to calculate on the balance sheet, is the present value of potential future cash flow. This is cash flow your company's has the potential to generate. As you can imagine, estimating a potential cash flow rather than a certain cash flow is quite theoretical and subject to alot of assumptions and inaccuracies
The table below is a good example of how poor estimations of intangible assets under the Net Asset Value approach can lead to the undervaluing of a company. This data was collected on the 16th of April 2019 from Yahoo! Finance, and shows the Book Value (balance sheet) and Market Capitalisation Value (based on share price) of four companies.
Based on this table, as of April the 16th 2019, Amazon was valued in the financial market at $907.77 billion but on Amazon's balance sheet, it was valued at only $43.55 billion. So where did the deficit value of $864.22 go to? The answer lies with the value of intangible assets captured on Amazon's balance sheets.
While Amazon’s Market Capitalisation might be overvalued, the Net Asset Value of Amazon based on its balance sheet is definitely inaccurate, as we all know Amazon is valued more that $43.55 billion. As of the 26th of August 2020, Amazon was valued at $1.7 trillion.
To conclude, always ensure that intangible assets are properly valued on your balance sheet and calculate the Intrinsic value of a large share investment before buying It.
For short term trading you might get away with not knowing what the Intrinsic value of a share is, but for investment portfolios and long term trading, always check the Intrinsic share value to determine if the share price is over value or undervalued.