DETERMING INTRINSIC VALUE OF A STOCK

Fundamental analysis provides investors an opportunity to anticipate whether a stock is undervalued, overvalued or at its fair market value.

Through this process, when an investor gets through all information about a company such as its future growth, sales figures, financial statements and more, it will provide them with an intrinsic value of the stock.

The market price of stock usually moves in the direction towards its intrinsic value according to long term investors who adopt fundamental analysis. The investor is likely to buy the stock if the intrinsic value of stock remains above the current market price. Whereas, in the opposite scenario, when the intrinsic value falls below the current market price, investors turn to sell off their stocks from the portfolio or take a short position.

Investment analyst usually tries to find the intrinsic value of a stock. There are various steps in the process of fundamental analysis that analysts and long term investors undertake to evaluate the financial stability of the companies and their performance to make decisions about investment purposes. However, once done with the whole process of screening the value of a company and financial statements have been thoroughly understood, they move on to determining the intrinsic value of a stock.

There are two simple models that can be beneficial for the investor interested in understanding the company. The two most commonly used methods for determining the intrinsic value of a firm are the “Dividend Discount Model”, also known as the Gordon Growth Model after the Canadian professor who developed it, and the Price/Earnings or PE model. If computed properly, both methods are expected to provide similar intrinsic values.

Dividend Discount Model

The kind of industry and the dividend policy of the industry is crucial while approaching the dividend discount model to choose which one of the dividend discount models to utilize. The intrinsic value of a share is termed as the future value of all dividend cash flows discounted at the appropriate discount factor.

For Constant Dividends:

P=Dt/ke where:

  • P= intrinsic value
  • Dt= expected dividend
  • ke= appropriate discount factor for the investment

 

This method is often used for evaluating preferred shares, in which dividend tends to be fixed. However, the constant dividend model does not take in future growth in the dividend payments and hence is known to be limited. Considering this, the constant growth dividend model may be more beneficial.

For Constant Dividend Growth:

P=Dt/(ke-g) where:

  • P= intrinsic value
  • Dt= expected dividend
  • ke= appropriate discount factor for the investment
  • g= constant dividend growth rate

 

This model is used for industries where the growth of dividend tends to be stable. With the help of constant dividend growth method mature blue chip stocks can be examined promptly and easily. This model permits adjustments to assumptions of timing and magnitude of the growth of the firm. However, this model has its own cons while taking a firm which is in the growth phase and is expected to move to a mature phase further in the future. In that case, a two-stage growth dividend model can be used. 

For the Two-Stage Growth Model:

Dividend growth model can be considered by investors to provide for two stages of different dividend growth whenever a company which is growing rapidly is suspected to grow slowly in near future.

P=Σnt=1[D0(1+g1)t/(1+ke)t]+Σt=n+1[Dn(1+g2)t-n/(1+ke)t]

where:

  • P= intrinsic value
  • D0= expected initial period dividend
  • Dn= expected dividend during mature period
  • ke= appropriate discount factor for the investment
  • g1= expected dividend growth rate for initial growth period
  • g2= expected dividend growth rate for mature period

 

Investors looking for companies that are at their initial stage or perhaps in a new industry can adapt this model as it is known for its flexibility provided in these kinds of situations.

 

Price Earning Model

The price-earnings model considers the earning per share of a company and then multiplies it with the Price earnings ratio. This model is known to be an easy one as it is convenient to compute this by getting earnings per share and share price. This is used to compare companies and for the target companies, estimates can be made easily. For example, if the best company in the industry had a PE multiple of 20 times and the worst a PE multiple of 10 times, then an average company in the industry may have a 15 times PE multiple. Afterward, taking the average company’s EPS, say Rs.1.00 per share, and multiplying it by 15 would give an intrinsic value of Rs.15.

Investors can acquire deeper information on companies and hence make viable decisions about stocks and respective investments as comparing and anticipating companies by their intrinsic values makes an investor aware about macroeconomic and political factors, which eventually assists investors to know about the company and get true insights into those companies’ value.