Calculate the Intrinsic Value of a Firm

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Value investors like to calculate the intrinsic value of a company's stock and compare it to the market price to determine mispriced stocks. We will cover three formulas for intrinsic value with examples. All calculations will be shown!

Intrinsic Value

What is a firm really worth? The financial markets value every company every day by stock price, but we know that is influenced by many macro variables that have nothing to do with the firm itself. The intrinsic value of a firm is its value with all of the external variables stripped out.

Value investors like Warren Buffet approximate intrinsic value and compare it with the stock market's valuation to identify stocks that have been mispriced. When the intrinsic value exceeds the market value, a stock is considered for purchase. Let's look at three ways to get at intrinsic value.

Constant Growth Model

Dividend growth models value a firm's stock based on what it returns to investors in dividends. A popular model useful for large companies with stable and growing dividends is the Gordon or constant growth model. It assumes that dividends will grow at a steady rate into the future. Here's the formula:


Gordon gowth


where:

V = value of the stock

D = dividend

r = required rate of return

g = dividend growth rate

Here's an example to illustrate. Big Co. pays a $4.00 dividend that is expected to grow by 3% each year. The required rate of return by the investor is 8%. Its stock value is:

$4.00 / (8% - 3%) = $4.00 / 0.05 = $80

The intrinsic stock value can be multiplied by the number of shares outstanding to get an intrinsic value for the whole company.

Multistage Dividend Discount Model

Another dividend model useful for small and fast-growing companies is the multistage dividend discount model. This model assumes that dividends will grow rapidly in the near future, but eventually level off into a stable rate for the long term. The formula requires us to discount the dividends for each year of the rapid growth phase, then discount the stock value for the remaining years using the Gordon Growth model we covered previously. Let's do this in steps with an example:

Small Co pays a dividend of $2.00 currently, and it expects to grow its dividend by 15% for the next two years, then level off at 5%. The required rate of return is 8%.

  1. Calculate the dividends for the high growth period. The current year dividend is expected to be $2.00, so the dividend for year 2 will be $2.00 * 1.15 = $2.30. For year 3 it will be $2.30 * 1.15 = $2.64.
  2. Calculate the intrinsic stock price at the end of year 3 using the Gordon constant growth model. This will reflect the discounted dividends for the stable growth period discounted to its value at the end of year 3. The calculation looks like $2.64 / (8% - 5%) = $88.
  3. Discount the dividends and stock value to the present using this formula:


Multi stage


Where V = intrinsic stock value, D1, D2 and D3 are the dividends for the rapid growth years, and P is the stock value at the end of the rapid growth period reflecting the out years. The r in the denominator is the required rate of return. Here's the calculation:

V = ($2.00 / 1.08) + ($2.30 / 1.17) + ($2.64 / 1.26) + ($88 / 1.26) = $1.85 + $1.97 + $2.09 + $69.84 = $75.75

Price Earnings Ratio

The stock market values companies based on multiples of earnings using the price to earnings ratio. It looks like this:


PE


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