9.17 Calculating - Intrinsic value

Intrinsic Value

The way to go is, search for stocks whose prospects you believe in (A good stock pick should consider effective management as it is everything in sustainable stock investment. Above average EPS growth rate and excellent ROE may be a good screening criteria from the market) and then use a valuation technique to ensure the purchase price is acceptable. Here, let us use the net present value (NPV) formula. How are we going to do it? Say if you are valuing Stock XYZ

From 5 years historical data, we get the information as above. To proceed, we also need to firm up our expectation based on your risk profile. In this example

1. We can set our investment horizon as long as 5 years from 2009. So that in 2015 we can use the fund to finance study of our children
2. We are confident that stock XYZ will continue growing 13 per cent per year for the next 5 years (last 5 years records prove this stock able to grow 13 per cent EPS per year)
3. Now let us assume stock XYZ will be having the same PER and dividend payout by end of 2015
4. Now we are realistically expecting 12 per cent return on investment (ROI) so that our investment will cover our expected costs in five years.

Let’s start calculating intrinsic value of stock XYZ

Step One: Forecast Share Price

First of all, we need to forecast our share price five years down the line- right? In this case let us project the price for the next five years using 13 percent yearly growth.

Forecasted Stock Price in 2015        =           EPS after 5th year x Average PER

=         11.71  ( 6.36 * 1.13 ^ 5) x 18.7

=          Rs.219

Step Two: Forecast Total Future Value

Secondly, you need to calculate the total future value. This must include the potential dividend as well.

Average Dividend Payouts =            Total Dividends/Total EPS

Total Dividends = Total EPS X Average Dividend Payout

= Rs. 52.91 x 4.5% = Rs. 2.38

Future Value@2015 = Forecasted Stock price in 2015+Total Dividends =Rs.219+Rs.2.38 =Rs.221.38

For some investors, dividend is just too small to be considered. But as it has effect to the total future value, it should be taken into consideration. With this method we can calculate the stock’s profitability to others who don’t pay any dividends at all.

Step Three: Calculate Intrinsic Value

Finally let’s calculate the intrinsic value for stock XYZ.

Intrinsic Value = Net Present Value= Future Value /Expected ROI ^ (No of Years)

Therefore Intrinsic Value  = Rs. 221/1.12 ⁵ = Rs. 125.40

Step Four: Compare with Current Stock Price

The intrinsic value above is because our goal is to get 12 per cent per annum from this stock. If so, current stock’s price, which is Rs.100, is acceptable indeed (Because stock price is below the intrinsic value). However, intrinsic value can be relatively different from one investor to another depending on the expected return. Expecting very high return will limit your investment options. On the other hand, having very low expected return is also not a viable strategy. So it is very important for us to keep a realistic target on the expected profits. Around 12% would be really ideal in current market situation.