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The intrinsic value of a stock is the present value of all cash flows it will generate for shareholders — dividends, buybacks, and ultimately liquidation proceeds. Unlike bonds, stocks carry no fixed maturity or promised cash flows, so valuation requires estimating uncertain future earnings and growth rates. The three main valuation approaches are discounted cash flow (DCF) models (theoretically rigorous), relative valuation using multiples like P/E (practical and widely used), and asset-based approaches. The gap between estimated intrinsic value and the current market price defines the investment thesis for active managers.
Start with the simplest case — a stock paying a constant, perpetual dividend — then relax assumptions to allow growth and varying payouts. Compare DCF outputs to actual market prices for real companies and understand what growth rates the market is implicitly pricing in.
You already understand present value: a dollar received in the future is worth less than a dollar today because you could have invested that dollar in the meantime. Stock valuation applies this idea directly. A share of stock is a claim on a portion of a company's future cash flows — primarily dividends, share buybacks, and ultimately whatever the firm would return to shareholders if it were wound down. The intrinsic value of a share is the present value of all those future cash flows, discounted at a rate that reflects their riskiness.
The simplest version of this is the Gordon Growth Model (dividend discount model with constant growth): V = D₁ / (r - g), where D₁ is next year's dividend, r is the required return, and g is the constant growth rate. If a company will pay a $2 dividend next year and dividends grow at 3% forever, and you require a 9% return, the stock is worth $2 / (0.09 - 0.03) = $33.33. This formula is elegant but fragile — the denominator r - g is small, so tiny changes in either input produce large changes in value. This sensitivity is why stock valuation is inherently uncertain even with a precise framework.
In practice, analysts use a multi-stage DCF model: they project specific cash flows for a near-term period (often 5-10 years), then add a terminal value for everything beyond that horizon. The terminal value typically uses a perpetuity formula and accounts for the bulk of the estimated value — often 60-80% of the total. Because the terminal value depends on assumptions about the long-run growth rate and discount rate, getting those assumptions slightly wrong has enormous consequences.
Relative valuation offers a practical alternative. Instead of modeling cash flows directly, you compare the stock's price-to-earnings (P/E) ratio, price-to-book, or enterprise value-to-EBITDA to those of comparable companies or to historical averages. The logic is that if Company A trades at 15x earnings and comparable Company B trades at 20x earnings with similar growth and risk, B may be overvalued relative to A. Multiples are fast and grounded in what real investors are actually paying — but they inherit whatever mispricing exists in the comparable companies.
The key insight from your prerequisite work on market equilibrium: market price and intrinsic value are not the same thing. In efficient markets, they converge quickly as informed investors trade on mispricings. In less efficient markets, or for less liquid stocks, they can diverge for extended periods. The investment thesis for any active manager — buying a stock they believe is undervalued — is fundamentally a claim that they have a more accurate estimate of intrinsic value than the current market price reflects.