It has been proven challenging to outperform the market, a task that remains tough even for professionals.

For new investors, opting for low-cost index funds or mutual funds that track the market, rather than attempting to beat the market through individual stock selection, can yield better returns.

Research also suggests that even seasoned investors would generally benefit from allocating the majority of their portfolio to low-cost index/mutual funds that track the market.

However, if you are an experienced investor who opts to allocate a portion of your portfolio to the research and investment in individual stocks, read on!

“Price is what you pay. Value is what you get.” — Warren Buffett

Value investing is one of the primary ways to generate long-term returns in the stock market. The fundamental investment strategy involves buying shares of companies trading at a price below their intrinsic value (calculated through one of several methods).

The core idea is that it’s challenging to predict daily stock price movements, but over the long term, the market will recognize the stock’s intrinsic value.

In practice, according to your calculations, the market has undervalued the stock because its price is below its intrinsic value. Knowing how to evaluate a stock is crucial to identifying an attractive price point.

Calculating a Stock’s Intrinsic Value

Measuring the book value of tangible assets like equipment and buildings is straightforward, but recording knowledge assets and intangible assets is more challenging and not found on financial statements.

Value investors understand that a company’s worth is not just its tangible assets, hence, expectations for a stock’s future growth and value are driven by this belief. Comparing a stock’s current trading price with its intrinsic value can reveal whether it’s undervalued or overvalued.

What exactly is intrinsic value? The question is, how do you assess a stock’s value?

There are several different methods to calculate a stock’s intrinsic value, how to automatically calculate a stock’s intrinsic value, and various methods to assess a stock. When attempting to determine a company’s true intrinsic value, many different values can be found.

Investment firms often look for several stock prices using different metrics, then apply the average of their results to their stock models.

Intrinsic Value

Unfortunately, identifying stocks trading below their worth isn’t as straightforward as buying shoes on sale. Stock prices don’t come advertised. They have their current trading prices, and the rest is left to analysis. Thus, figuring out how to calculate a stock’s intrinsic value is crucial.

Intrinsic value is a measure of a stock’s worth. If a stock’s trading price is above its intrinsic value, then its price is too high; if a stock’s trading price is below its intrinsic value, then its price is too low, essentially on sale.

To determine a stock’s intrinsic value, fundamental analysis is necessary. Establishing a valuation model requires considering qualitative, quantitative, and perceptual factors.

Fundamental Analysis

Fundamental analysis involves analyzing financial and economic factors related to a company’s performance. If you’re wondering how to evaluate a company’s stock, this is a good starting point.

Qualitative Factors

Qualitative factors are specific aspects related to the company’s business nature and way of operation. These factors are not measurable. For example, company morale, governance, relationships with consumers, and the business model.

Quantitative Factors

Quantitative factors are aspects of a company’s performance that can be reliably measured. This includes a company’s financial statements and various ratios and valuation metrics.

Perceptual Factors

Perceptual factors are derived by determining investors’ expectations and perceptions of a stock.

All these factors are combined as objectively as possible to establish a mathematical model used to determine a stock’s intrinsic value. Obviously, due to the nature of many qualitative factors and assumptions, there remains a degree of subjectivity. After estimating the intrinsic value, it’s compared with the stock’s current market price to determine if the stock is overvalued or undervalued.

Valuation discrepancies may arise from individual analysts giving different weights to various factors. For instance, a company’s management team might be considered a high-value determinant by one analyst, while another might place higher weight on profits as a value-driving factor.

If an analyst values profits over management, they might mistakenly identify an undervalued stock because they focus solely on steady profits, overlooking poor management team performance. In other words, their analysis, based on the financial data they see, indicates the stock is undervalued, but the trading price is low due to overall poor management team performance.

You can combine all different types of measurement factors, but ultimately the stock’s intrinsic value is still just an estimate.