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Arora & Shaw, Apeejay - Journal of Management Sciences asnd Technology 3 (1), June- 2014

( ISSN -2347-5005)

30

Analysis of Gap in Intrinsic and Market Value of

Companies

Chitra Bhatia Arora Rajesh ShawSchool of Management Angel Broking Ltd.

Apeejay Institute of Technology, Greater Noida New Delhi

_____________________________________________________________________________________________________________________

Abstract: Wide gap between Intrinsic and market value of the company indicates existence of inefficiencies in the

market. Empirical results and graphs indicate that intrinsic value is often overlooked by irrational investors,

which further increases inefficiency in the market. Prices, sales, P/E ratios are normally distributed. Multipliers

explain the change in intrinsic value more appropriately than other factors like sales. Fragile expectations of

investors derive market price away from intrinsic value, both at recovery and boom phase of stock market.

Key Words: Intrinsic Value, Market Value, Inefficiency

_____________________________________________________________________________________________

I INTRODUCTION

It is constant practice by analysts in the market to identify the intrinsic value of the company for long term

investment. The efficient market reduces the gap between two values. Intrinsic value is derived from fundamentals

of the companies that is sales, profitability, earning per share and operating efficiency. Market price of the shares

which is dependent on demand and supply of the shares in the market. It may be affected by key market players

operational in the market. Identification of such players is herculean task for common investors. This also derives

speculation in the market and often the reason of overvaluation and undervaluation of the shares. It has been a

constant debate among researchers to identify which value to be considered for making investment decision.

Moreover, what pushes the market value away from intrinsic value of the share? To calculate intrinsic value has

been a challenging task for experts. Behavioural finance theories say that in long run market prices cannot stay away

from its equilibrium price/intrinsic value. In cobweb structure of price movement arbitrators will bring the prices to

equilibrium price indicating damped oscillations. This behaviour of price also indicates that investor has to be

cautious while investing and should not overlook the fundamentals of the company. The share is under- priced when

intrinsic value of the share is greater than the market price. Analyst advice pick of such stock in the market for long

run. In the similar manner, share is tagged over-priced when the market price is greater than the intrinsic value of the

share. Intrinsic value is the present value of future gains in the market. Expected gains that are dividend and capital

gain which depend on realised events and holding period of the stock by the investor. Market price on the other hand

is combination of discounted value of expected fundamentals and irrational expectations of investors in the market.

In perfect market Fama [1] role of sophisticated investor nullifies the gap between market price and intrinsic value

of the stock.The price of the share is basically derived from the earnings of the share. EPS (Earning per Share)

calculates the rate of return on the equity. Other vital decision of management like distribution of dividend also

impacts the returns of equity holders. Walter Model as well as Gordon model of calculating equity price indicates

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that if rate of return is high in future projects of the company reinvestment of profit will maximise the value of

equity, whereas, vise-versa in such situation may bring the equity price down.

In this paper intrinsic value is calculated on the basis Ben Graham’s formula for calculating intrinsic value. V =

EPS*(8.5+2G), EPS (12 month)

EPS=Earning Per Share =Net Profit after Interest and Tax/Outstanding Shares

8.5 = P/E base for a no growth company

G = reasonably expected 7 to 10 year growth rate

II REVIEW OF LITERATURE

Behavioural finance theory explains the behaviour of price through chartist theory, fundamental theory, Random

Walk Model and Efficient Market Hypothesis. If chartist theory prevails which claims that past prices explains the

current and future price then Random Walk theory rules out. Whereas, RWM propounds that stock market is a

speculation and nothing is predictable. Fama [2] in his Ph.D thesis discussed Random Walk Model theory in details.

He propounded a thought that if RWM prevails in the market then chartist theory and fundamental theory cannot

stand. Many empirical experiments in the paper supported that successive changes in the prices are independent. He

further stated that major stock exchanges are good example of efficient market where large number of rational profit

maximizers actively competing with each other. In an efficient market at any point in time the actual price of

security will be a good estimate of its intrinsic value.

Ja Ryong Kim [3], stated that stock price is the sum of realized events and price of expectation of future events,

which influence company’s future cash flow. He found multiplier more effective to calculate intrinsic value than

discounted cash flow .PriceStock= Price (Realised Events)+Price (Expectation) which when elaborated give

equation Price Stock=Price (Realised Events)+ Price (Expectation)+Price (Irrational Expectation). Price (Realised

Events) is price based on past events (accounting information), Price (Expectation) based on market or company

fundamental. Price Irrational Expectation based on (rumour, discontinuous information. Price Intrinsic Value= Price

(Realised Events)+ Price(Rational Expectation). In his paper he assumed that Price Irrational Expectation=0. The

most basic valuation model is book value. Book value estimates the price of realised events, it fails to incorporate

information on expectation, thereby generates large difference between stock price and estimate.

III OBJECTIVES

The study focuses on following research questions: (i) Does gap exist between Intrinsic and Market value of the

stock? (ii) Which factors appropriately explains the change in intrinsic value? (iii) Does Intrinsic value of stock

explain the change in the market price of the stock?

IV EMPIRICAL ANALYSIS

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A. Tables

TABLE I

DESCRIPTIVE STATISTICS OF TATA MOTORS

TATA Motors Ltd Intrinsic Value Market Value Sales Net Profit P/E Ratios

Mean 574.76 219.44 127981.69 6541.81 4.91

Standard Error 187.83 39.17 21964.55 2872.08 1.72

Median 398.75 211.77 122127.92 9220.79 4.67

(t value) 0.93 0.195 0.266 0.93 0.13

Mode N/A N/A N/A N/A N/A

Standard Deviation 419.99 87.58 49114.24 6422.16 3.83

Sample Variance 176398.09 7670.36 2412208782 41244221.82 14.73533

Kurtosis 4.36 1.36 -2.08 -1.04 0.85

Skewness 2.051 -0.207 0.18 -0.61 1.04

From the above table following inferences maybe drawn(i)K< 3 in all cases that is intrinsic value, market-value,

sales, net profit and P/E ratios which is platykurtic distribution, flatter than a normal distribution with a wider peak.

The probability of extreme values is less than for a normal distribution;(ii) Skewness of all variables lies between +1

and -1 showing symmetric distribution;(iii) difference between mean and median is not significant in any of the

above case; (iv) Standard deviation of intrinsic value is high in comparison to market value which is obvious as SD

of fundamental values are high; overall the five years data of Tata Motors are normally distributed.

TABLE IIDESCRIPTIVE STATISTICS OF HDFC BANK LTD.

HDFC Bank Ltd Intrinsic Value Market Value Sales Net Profit P/E Ratios

Mean 469.84 466.96 28401.81 4295.28 12.736

Standard Error 107.83 65.83 4463.77 824.25 4.475

Median 483.87 454.08 24628.38 4017.69 6.11

(t value) 0.13 0.28 0.36 0.33 1.48

Mode N/A N/A N/A N/A N/A

Standard Deviation 241.1345 147.20 9981.298 1843.08 10

Sample Variance 58145.85 21668.16 99626320 3396959.97 100.159

Kurtosis -1.56 -0.371 -0.92 -0.749 -3.13

Skewness 0.238 -0.179 0.88 0.535 0.634

Above table shows that distribution of data is symmetrical and normal. Though standard deviation is high which

indicates fluctuation in prices, especially SD of intrinsic value is higher than the market value.

TABLE IIIDESCRIPTIVE STATISTICS OF DLF LTD.

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DLF Ltd Intrinsic Value Market Value Sales Net Profit P/E Ratios

Mean 96.676 258.606 8893.82 1939.29 32.062

Standard Error 35.483 26.152 530.618 671.46 6.865

Median 67.6 237.37 9560.57 1638.02 30.71

(t value)

Mode #N/A #N/A #N/A #N/A #N/AStandard Deviation 79.344 58.478 1186.499 1501.43 15.35239

Sample Variance 6295.50 3419.78 1407781.502 2254294.183 235.696

Kurtosis 4.021 -2.978 -2.905 3.6223 -0.546

Skewness 1.937 0.427 -0.532 1.794 -0.0061

TABLE IV

DESCRIPTIVE STATISTICS OF BHARTI AIRTEL LTD.

Bharti Airtel Ltd Intrinsic Value Market Value Sales Net Profit P/E Ratios

Mean 174.362 338.656 28401.81 4295.28 12.736

Standard Error 60.501 8.089 4463.772 824.252 4.475Median 168.49 454.08 24628.38 4017.69 6.11

(t value)

Mode #N/A #N/A #N/A #N/A #N/A


Sample Variance 18302.19 21668.16 99626320 3396959.97 100.159

Kurtosis 0.072 -0.371 -0.92432 -0.749 -3.129

Skewness 0.831 -0.1791 0.88049 0.53581 0.6343

TABLE V

DESCRIPTIVE STATISTICS OF ACC LTD.

ACC Ltd Intrinsic Value Market Value Sales Net Profit P/E Ratios

Mean 560.29 1048.77 9884.92 1211.876 17.01

Standard Error 45.317 108.46 664.08 98.013 2.59

Median 500.14 1090.58 10237.19 1081.73 16.51

(t value) 1.327 0.38 0.53 1.327 0.196

Mode #N/A #N/A #N/A #N/A #N/A


Sample Variance 10268.37 58820.50 2205073.09 48032.76 33.571

Kurtosis 1.061 -0.113 -2.93 1.059 0.487

Skewness 1.385 -0.817 -0.298 1.38 -0.789

Standard Deviation is high in all cases which are obvious as prices change every second in the market which derives

the prices away from equilibrium moreover, yearly average prices moves or drifts a part from previous year’s price.

Kurtosis and Skewness is within range indicating normal distribution of prices, sales, market value and net profit.

TABLE VI

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REGRESSION RESULTS (Market value): MktVt=α0+β1IntVt

Company Intercept β 1 R 2 F

ACC Ltd 2137.69 -1.943 0.65 5.81

(t) 4.67 -2.41

Bharti Ltd -1385.97 4.61 0.37 1.83

(t) -1.20 1.35

DLF Ltd 215.55 0.445 0.365 1.72

(t) 5.30 1.31

HDFC Bank Ltd 623.04 -0.33 0.29 1.26

(t) 4.07 -1.12

Tata Motors Ltd 246.75 -0.047 0.052 0.164

(t) 3.065 -0.405

From the above results following inferences are drawn (i) the above model is not the best fit ,as intrinsic value does

not explain the change in market price ;(ii) intercept is significant in all cases except Bharti this indicates that fixed

variable give significant effect on market price of the share like fundamentals of the company;(ii) Coefficient of

market price is significant in only one case that is ACC ltd, this result is obvious as market price is determined by

the demand and supply of shares and intrinsic value depends on the fundamentals of the company. These results

further raise the question mark on the efficiency of the market, where investor is considered to form expectation on

the bases of the fundamentals of the company. New set of information according to Fama brings adjustment in the

price. The first impact will be on intrinsic value of the stock . this further indicates strong impact on market price but

above results contradicts the theory of finance.

TABLE VII

REGRESSION RESULTS (Intrinsic value): IntV= α0+β1Sales


ACC ltd 893.23 -0.033 0.243 0.96

(t) 2.613 -0.98

Bharti Ltd 568.57 -0.006 0.86 18.87

(t) 6.025 -4.34

DLF Ltd -277.53 0.042 0.395 1.96

(t) -1.03 1.40

HDFC Bank Ltd 811.52 -0.079 0.369 1.759

(t) 2.941 -1.326

Tata Motors Ltd 820.31 -0.0019 0.05 0.159

(t) 1.26 -0.398

Above results indicate that above model is not the best fit model as sales does not explain the changes in the intrinsic

value . (i)Coefficient of intercept is significant in three out of five cases that indicates that other fixed factors

provide greater impact on the intrinsic value of the stock; (ii) Coefficient of sales is significant in one case that is

Bharti Ltd, which indicates that in most cases change in sales does not bring significant change in the intrinsic value,

the result is surprising as revenue is the main determinant of efficiency of the company.

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TABLE VIII

REGRESSION RESULTS (Intrinsic value): IntV= α0+β1P/E (Price/Earning Ratio)


ACC Ltd 832.99 -16.032 0.84 15.788

(t) 11.61 -3.97

Bharti Ltd 334.41 -5.31 0.81 12.78

(t) 6.17 -3.5748

DLF Ltd 237.97 -4.40 0.72 7.99

(t) 4.37 -2.827

HDFC Bank Ltd 743.01 -21.44 0.79 11.45

(t) 7.531 -3.384

Tata Motors Ltd 924 -71.186 0.423 2.202

(t) 3.216 -1.48

Above table indicates that given model is the best fit and explains the change in the intrinsic value of the stock. This

further clears the thought that only market price does not explain change in intrinsic value but ratio of price and

earning is the true parameter of efficiency of the company, maybe operational efficiency and leverage maximises the

earning of shareholders and this brings change in intrinsic value of the share. (i) Coefficient of intercept is

significant in all the cases which indicates the great influence of other factors on intrinsic value ; (ii) coefficient of

Price/Earnings ratio is significant indicating significant impact of change in P/E on Intrinsic value. Moreover, all

coefficients are negative, indicating reverse impact of increase and decrease of P/E ratio. This may be justified as

increase in P/E may be due to increase in price or reduction of earnings of shareholder, in both cases intrinsic value

will come down.

B. Charts of Intrinsic and Market Value

Fig. 1 ACC Ltd.

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Fig. 2 Bharti Ltd.

Fig. 3 DLF Ltd

Fig. 4 TATA Motors Ltd.

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Fig 5 HDFC Bank Ltd

In the above figure intrinsic value was higher than market value from 2009 to 2011. Intrinsic value went below

market value in 2012, this further indicates that in recovery phase of the market , market value generally shootsup.

Charts indicate that in all cases market value is higher than intrinsic value of the stock except Tata Motors from

2009 to 2013. This may be inferred that Tata Motors is undervalued and good buy for long term investor. In ACC,

Bharti and DLF the gap between market and intrinsic value widened from 2009 to 2013 which indicates that traders

are bullish on these stocks whereas in Tata Motors the gap was huge in year 2011 indicating huge change in the

structure of the company. Investors are not bullish on Tata Motors but situation seems to be changing in year 2013.

V FINDINGS

1. There is wide gap between intrinsic and market price, which raises doubt on the efficiency of the market or

maybe new dimension in the model of intrinsic value is required which can bring intrinsic value near market

value.

2. Intrinsic value fails to explain change in market price which further indicates existence of irrational expectation

of investor in the market. This further widens the gap between intrinsic and market price.

3. Yearly average prices, sales and profitability of the stock of the company are normally distributed. This is also

an indication of less volatility in the given variables or maybe the result would have been different if daily

prices are taken.

4. In stock recovery phase or at boom period market prices are generally higher than intrinsic value due to

increasing expectation of investors. High expectation increases demand and pushes market prices away from

its intrinsic value. This also indicates herd behaviour of investor in the market.

REFERENCE

[1] Eugene F. Fama (1975), “Efficient Capital Markets: A Review of Theory and Empirical work” ,The Journal of Finance, Vol 25, No 2, Black

Well American Finance Association. May 1975.

[2] Eugene F. Fama, “The Behaviour of Stock Market Prices”, The Journal of Business, Vol. 38, No. 1 (Jan., 1965), pp. 34-105, The University

of Chicago Press

[3] Ja Ryong Kim, “Measuring the Intrinsic Value”, The University of Edinburgh Business School.

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OTHER REFERENCES

Bruce N.Lehmann, “Asset Pricing and Intrinsic Values: A Review Essay”, NBER Working Paper No.38 B, Oct 1991.

Stefan Palan, “The Efficient Market Hypothesis and it’s Validity in Todays Markets” Ph.D Thesis, Aug 2004.

Eugene F. Fama, “Random Walks in Stock –Market Prices”, Graduate School of Business University of Chicago. Paper No 16.

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