Any asset has value in and of itself, that is without any influence from external factors. Stocks are no exception. The market value of stocks is influenced by many external factors. The condition of the economy and the latest numbers for GDP and unemployment move market prices. So do political things like pending legislation, and presidential tweets! The intrinsic value of a stock, on the other hand, attempts to boil out the externals and value a company on its own merits. Internal factors like a firm's products, its management, and the strength of its brands in the marketplace determine intrinsic value.
Investors are interested in cash available to stockholders. The internal factors above determine how much cash a company can expect to generate. So the methods we will learn that compute intrinsic value are based on cash generated and expectations for future growth.
Analysts and investors calculate intrinsic values for an important reason, they identify under-priced stocks. If an investor calculates an intrinsic value of $300 for a stock, and it is trading on the market for $250, it will be perceived as a bargain price and a good investment.
The dividend discount method (DDM) is a quick and easy way to evaluate intrinsic value. It is especially useful for large, stable companies. The commonly used formula for the Gordon Growth version of the DDM is focused on dividends, which are cash paid to stock holders and their future growth. It is:
Intrinsic Price of Stock = DPS1 / (r - g)
where:
DPS1 = Expected dividends one year from the present
r = The discount rate or required rate of return on the investment
g = The annual growth rate of dividends in perpetuity
For instance, Mountain Energy Company is an established public utility with a stable customer base. It expects to pay a $15 dividend per share this year, which has had a stable 3% growth over the years. We will use 3% for g in the formula. The required rate of return for this type of investment is 8%, which is r in the formula. The intrinsic value of Mountain Energy Company's shares is:
$15 / (.08 - .03) = $300
The most widely used method for getting at intrinsic value is the discounted cash flow (DCF) method. It uses free cash flows rather than dividends to come up with a value. This method is also very flexible in that it allows for cash flow estimates to vary from year to year and works for any size company!
Let's go through a simple example step-by-step. Cy Cycles carries a full line of road and mountain bikes. Cy and his partners have two very successful retail locations and plan an aggressive expansion over the next five years. They want to issue 3,000 shares of stock to investors and family members who will put down their money and make the growth possible. Cy and his partners are interested in estimating the intrinsic value of these shares. Beth is the partner who is the wizard of finance for the business! She and Cy are going to go through the steps to find out.
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1. Project free cash flow for the forecast years. Cy expects to have $10,000 in free cash flow for the current year. He expects that cash flows will grow by 20% each year for next five years.
2. Come up with a discount rate. The number to focus on is assumed cost of equity. Beth tells Cy she will use 8%.
3. Discount the projected free cash flows to present value. Beth has worked up a table that shows the estimated cash flows discounted for the first five years. Here it is:
| Year | Cash Flow | Discount Calculation | PV of Cash Flow |
|---|---|---|---|
| 1. | $10,000 | $10,000 / 1.08 | $9,259 |
| 2. | $12,000 | $12,000 / 1.08^2 | $10,288 |
| 3. | $14,400 | $14,400 / 1.08^3 | $11,431 |
| 4. | $17,280 | $17,280 / 1.08 ^4 | $12,701 |
| 5. | $20,736 | $20,736 / 1.08 ^5 | $14,113 |
The sum of the discounted cash flow is $57,792.
4. Calculate the discount perpetuity value. They will next do a perpetuity for all of the years after year 5. What they first need to do is come up with a realistic growth rate for those years. Beth reminds Cy of how uncertain the world is and that they should be conservative and go with a low number. They agree on 4%.
Beth is going to take the cash flow in year 5 and calculate the perpetuity. Here is the formula:
Perpetuity Value = (CFn * (1+ g) ) / (r - g)
Where CFn is the cash flow at the end of year 5.
r is the discount rate.
g is the growth rate.
So the calculation looks like ($20,736 * (1 + .04) ) / (.08 - .04) = $21,565 / .04 = $539,125. But that is the value at the end of year 5. We need to find its present value by discounting just like in the table for the early years. So $539,125 / 1.08^5 = $366,919.
5. Add up the sums of the present values. The sum of the discounted values first five years is $57,792. The discounted perpetuity value for the outer years is $366,919. The sum is $424,711.
6. Divide the sum total by the number of shares. $424,711 / 3,000 shares = $141.57 per share, that is their intrinsic value!
The intrinsic value of a stock is a price for the stock based solely on factors inside the company. It eliminates the external noise involved in market prices.
A quick and easy way to calculate intrinsic value is the dividend discount method (DDM). It works best for large and stable companies. The simple formula is:
Intrinsic Price of Stock = DPS1 / (r - g)
where:
DPS1 = Expected dividends one year from the present
r = The discount rate or required rate of return on the investment
g = The annual growth rate of dividends in perpetuity
Another widely used method is the discounted cash flow (DCF) method. It uses cash flows from the business rather than dividends to come up with a value. It is flexible since actual cash flows projections can be used for different years and time frames. They are then discounted back to present value to arrive at the intrinsic value.
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