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Lesson 1 of 9 · 11 min

Intrinsic value, mispricing and the three model families

Valuation means estimating what a share is worth from its fundamentals and comparing that estimate with the market price, using one or more of three model families.

Video lesson · 6 min. Watch it first, then use the text below to go deeper.

In short

Intrinsic (fundamental) value comes from analysing the business; the market price is what the share trades at today.
Value > price → undervalued; value = price → fairly valued; value < price → overvalued.
Act only when the gap is large relative to your confidence in the model and inputs, and when you expect the price to converge to value.
Three model families: present value (discounted cash flow), multiplier (price or EV multiples) and asset-based (assets minus liabilities).
Analysts often use several models and a range of inputs; the choice depends on the data available and confidence in it.

Value versus price

Fundamental analysis uses information about the economy, the industry and the company to estimate what a security is worth. That estimate is its intrinsic value (also called fundamental value). Analysts may work top-down (economy → attractive sectors → companies) or bottom-up (forecast the companies in an industry directly).

Estimating intrinsic value quietly assumes that the market price is not necessarily the best estimate of value. If it always were, there would be nothing to find. This is why valuation matters most in active management, which tries to beat a benchmark by spotting mispriced securities.

The comparison is simple. If your value estimate is above the price, the share looks undervalued (a buy candidate). If it equals the price, it looks fairly valued. If it is below the price, it looks overvalued (a sell candidate).

When you have a range of estimates rather than one number, compare the price with the whole range. A price inside the range suggests fair value; a price above the top of the range suggests overvaluation; a price below the bottom suggests undervaluation.

Comparison	Conclusion	Typical response
Value estimate > market price	Undervalued	Consider buying
Value estimate ≈ market price	Fairly valued	Hold / no action
Value estimate < market price	Overvalued	Consider selling

Halvorsen's estimate is above its price (undervalued), Brivio's is almost equal to it (fairly valued) and Kestrel's is below it (overvalued). The gap only matters if it is large relative to the uncertainty in the estimate.

Confidence and convergence

In practice the decision is not mechanical. Every model is a simplification, and every input is uncertain. So the conclusion depends on the size of the gap and on how confident you are in the model and its inputs.

With low confidence, demand a wide gap before acting. If your estimate is 30.00 and the price is 30.15, a 0.5% difference sits well inside the error of any model; calling the share fairly valued is sensible.

You also need confidence that the price will move toward your value estimate within your investment horizon. A correct estimate earns nothing if the market never comes round to it.

Treat market prices with both scepticism and respect. If almost everything you analyse looks mispriced in the same direction, especially in a widely followed segment, recheck your models and inputs before acting. Mispricing is more plausible in securities that few analysts follow.

A value estimate is only the first step. A recommendation needs a gap that is large relative to model uncertainty and a reason to expect the price to move toward value.

Three families of valuation models

Present value models (also called discounted cash flow models) value a share as the present value of the benefits it is expected to deliver. Those benefits are either the dividends expected to be paid (dividend discount models) or the cash available to be paid out after capital spending and working capital needs (free-cash-flow-to-equity models).

Multiplier models (also called market multiple models) use a ratio. A price multiple divides the share price by a per-share fundamental such as earnings, sales, book value or cash flow (P/E, P/S, P/B, P/CF). An enterprise value multiple divides enterprise value by a fundamental such as EBITDA or revenue. The fundamental can be trailing (last year) or forward (next year's forecast), as long as you use the same basis for every company you compare.

Asset-based models estimate the value of the company's assets, subtract the value of its liabilities and preferred shares, and divide by the number of common shares. Market values are usually found by adjusting book (carrying) values. The idea is that a business is worth the sum of what it owns, net of what it owes.

Because each model simplifies reality, analysts often use more than one and test a range of inputs. This also shows how sensitive the estimate is. Which models you lean on depends on the information available and how much you trust it.

Family	Value comes from	Examples
Present value	PV of expected future benefits	Dividend discount model, FCFE model
Multiplier	A multiple × a fundamental	P/E, P/B, P/S, P/CF, EV/EBITDA
Asset-based	Market value of assets − liabilities − preferred	Adjusted book value

A quick way to spot the family: discounting future cash flows → present value; a ratio such as P/E or EV/EBITDA → multiplier; adjusting the balance sheet → asset-based.

Formula

Apparent mispricing: $\text{Mispricing} = \dfrac{V_0 - P_0}{P_0}$
V0 = intrinsic value estimate, P0 = market price. Positive → undervalued, negative → overvalued. Only meaningful if the gap is large relative to estimation error.

Worked examples

Example 1 Point estimate versus price

An analyst values Halvorsen ASA at NOK 42.00 per share. The shares trade at NOK 36.50. How does the share look, and by how much does value exceed price?

Example 2 Value range versus price

Using several models, an analyst estimates Brivio SpA's value at EUR 31 to EUR 35. What is the conclusion if the price is (a) EUR 33.40, (b) EUR 38.20, (c) EUR 29.10?

Example 3 Identifying the model family

An analyst takes Kestrel plc's earnings per share of GBP 2.40, applies the industry's average P/E of 14.5 and arrives at a value of GBP 34.80. Which kind of model is this, and what would be a reasonable first step if the analyst found that every company in this heavily researched industry looked overvalued?

On the exam

Expect a value estimate or range against a price with three labels (overvalued, undervalued, fairly valued), and questions asking which model family a described method belongs to or what an analyst should do when results look implausible.

Reversing the labels: a value estimate above the price means undervalued, not overvalued.
Calling a share mispriced when the price lies inside the analyst's range of estimates.
Treating EV/EBITDA or price-to-free-cash-flow as present value models: they are multiplier models.
Acting on every small gap without considering confidence in the inputs and whether the price will converge.

Check yourself

Q1An analyst's models give intrinsic values between 46.00 and 52.00 for a share trading at 55.80. The share is most likely:
Q2An analyst finds that 18 of the 20 heavily researched large-cap stocks she covers appear undervalued. Her most appropriate first step is to:
Q3An analyst values a share by multiplying the company's sales per share by the median price-to-sales ratio of its peers. The analyst is using:
Q4An analyst has little confidence in the inputs to her valuation model. Before acting on an apparent mispricing she will most likely require:
Q5Mispricing is most likely to be common and persistent in securities that are:

0/5Check yourself

Answer the 5 questions: +10 XP for each one you get right first time.

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