Intrinsic value vs price, and the three families of valuation models

How do you decide whether a share is cheap or expensive?

Estimate what the share is worth, then compare that estimate with what it costs. Intrinsic value is the value of a share based on an analysis of the company’s fundamentals, which is why it is also called fundamental value. The market price is what the share trades for now. By estimating a value at all, the analyst is saying the market price is not necessarily the best estimate of worth.

The comparison gives one of three verdicts.

Intrinsic value estimate V against market price Pa verdict only counts if the gap is bigger than your uncertainty

• Undervalued Memorize V above P; a candidate to buy
• Fairly valued Memorize V equals P, or P sits inside your error band
• Overvalued Memorize V below P; avoid, sell or short

If the value estimate is above the price, the share is undervalued : you would pay less than it is worth. If the estimate is below the price, it is overvalued . If the two are equal, or the price is close enough to the estimate that the gap sits inside your uncertainty, it is fairly valued .

$$\text{gap} = \frac{V}{P} - 1$$

Two judgments before you act

A value estimate is a range, not a point. Two questions decide whether the verdict is worth acting on.

1. How confident are you in the model and its inputs? A gap of 0.5% is noise. Analysts often run several models and a range of inputs. If the price falls inside that range, the share is fairly valued, even if your central estimate is a little higher or lower. If it falls outside the whole range, the verdict is much stronger. A range of CHF 58 to 66 against a price of CHF 71 points to an overvalued share even on your most generous inputs.
2. How confident are you that price will move to value within your horizon? An undervalued share pays off only if the market comes to agree with you.

Respect the market too. If nearly everything you analyze looks overvalued, or nearly everything looks undervalued, recheck your model before you recommend anything. Mispricing is more plausible in shares that few analysts follow than in widely covered ones.

Exam tip A gap inside your error band is “fairly valued”. Do not call it cheap or dear just because the sign is positive or negative.

What are the three families of valuation models?

Models that estimate intrinsic value fall into three families. They differ in what they treat as the source of a share’s worth.

Equity valuation modelsanalysts often use more than one and compare

• Present value (discounted cash flow) Use it PV of cash flows to shareholders
  • Dividend discount model cash flow is dividends
  • Free-cash-flow-to-equity model cash flow is dividend-paying capacity
• Multiplier (market multiple) Use it a multiple of a fundamental
  • Price multiples P/E, P/B, P/S, P/CF
  • Enterprise value multiples EV/EBITDA, EV/sales
• Asset-based Use it fair value of assets minus liabilities

Present value models value a share as the present value of the cash it is expected to deliver to shareholders. They are also called discounted cash flow models . The cash flow is either dividends (dividend discount models) or the cash left for shareholders after the company’s reinvestment and debt flows (free-cash-flow-to-equity models). The next three lessons build them.

Multiplier models , also called market multiple models , value a share by applying a multiple to a fundamental such as earnings, sales, cash flow or book value. A price multiple (P/E, P/S) goes straight to a price. An enterprise value multiple (EV/EBITDA, where EBITDA is earnings before interest, taxes, depreciation, and amortization) goes first to the value of the whole business, and the claims of lenders and preferred holders are then subtracted to reach equity.

Asset-based valuation models value a share as the estimated fair value of the company’s assets minus the fair value of its liabilities and preferred shares. Fair value usually starts from the balance sheet’s carrying value (also called book value) and is adjusted toward market value.

Family	Values the share as	Examples	Advantages	Disadvantages
Present value	PV of expected cash flows to shareholders	dividend discount model, free-cash-flow-to-equity model	grounded in theory; forces explicit assumptions	very sensitive to the required return and growth; long forecasts needed
Multiplier	a multiple of a fundamental	P/E, P/B, P/S, P/CF, EV/EBITDA	widely used; easy to compute and compare; reflects market views	relative only, so a whole sector can be mispriced; accounting differences; trailing multiples ignore the future; negative earnings
Asset-based	fair value of assets minus liabilities	adjusted book value, replacement cost	suits firms with mostly tradable or marked-to-market assets, and liquidations	hard for intangibles and specialized assets; poor for going concerns with large intangibles; inflation distorts values

The choice depends on what information you have and how far you trust it. An analyst valuing a company with one year of history has little basis for a long cash flow forecast, but its young assets probably sit close to market value and industry multiples are available. That analyst would lean on the multiplier and asset-based estimates and trust the present value estimate least. Using all three and comparing them is a cross-check, often called triangulation.

Go deeper Why analysts still look at the market price

A model that returns a value far from the price is not automatically right. The price is the combined judgment of many investors, so a big gap is a prompt to ask what the market sees that the model does not. Sometimes the answer is a better input. Sometimes the answer is that the market is wrong, and that is the opportunity. Either way, the price works as a sanity check on the model, not as the answer.

Go deeper A correct estimate can still lose money

Suppose your value estimate is exactly right, yet the price stays below it for three years. If your horizon is one year, you take the loss of waiting. Convergence risk is why the verdict needs a second judgment. It is also why fundamental analysts care about catalysts such as earnings releases or a change in the capital return policy.

Go deeper Technical vs fundamental analysis, top-down vs bottom-up

Technical analysts use prices and trading volume to predict price moves. Fundamental analysts estimate value from information about the economy, the industry and the company, and compare it with the price. A top-down approach starts with the economy, picks promising sectors and then picks companies. A bottom-up approach starts with a few industries and forecasts company fundamentals one at a time. Valuation matters most in active management, which tries to beat a benchmark by finding mispriced shares.