Intrinsic value of the security is the value of its own, which it enjoys due to the fundamentals of the company.
Relationship between Market Value and Intrinsic Value
Market value > Intrinsic value Stock is overpriced
Market value = Intrinsic value Stock is correctly priced
Market value < Intrinsic value Stock is underpriced
Dividend Discount Model
the intrinsic value of a stock is the present value of all the cash flows expected from the stock
Himanshu wants to buy Abhishek Industires stock and hold on it for five years. He estimates that Rs 4.05 dividend would be paid by the company continuously for the next five years. He hopes to sell the shares at Rs 75 at the end of the fifth year. If his required rate of return is 10%, then what price he should pay at present?
Using Historical Dividends
Using Historical Earnings
Using Return on equity and payout ratio
G= (1-Payout ration) X Return on Equity
Or g= Plough back Ratio x ROE
Arithmetic Mean Rate
Compound Annual Growth Rate (CAGR)
Where x1, x2……. are the annual returns for the respective years.
It gives the smoothed annualized gain of an investment over a given time period.
CAGR is often used to describe the growth over a period of time of some element of the business.
CAGR dampens the effect of volatility of periodic returns that can render arithmetic means irrelevant.
V ( t 0 ) : start value, V ( t n ) : finish value, t n − t 0 : number of years.
Actual or normalized values may be used for calculation as long as they retain the same mathematical proportion.
The CAGR can also be calculated as the geometric mean of the decimal multiplier equivalents of the individual period-over-period changes.
t n − t 0 = 2007 - 2004 = 3 Calculating CAGR gives: Year 2004 2005 2006 2007 Revenues 100 115 150 200
An investor owns the share of Natural Waters Ltd., whose current cash dividend id Rs 3. The constant growth rate in dividend is 16 percent per year and the required rate of return is 20 percent. What is the value of the company’s share?
Single stage model only suitable for determining the value of stocks of an established company.
Model assumes that growth rate after n years remains constant and company after the initial abnormal growth settles to normal growth.
Abnormal growth stage
Constant (or normal) growth stage
Total value of a two-stage growth stock
Determine the intrinsic value of an equity share, given the following data:
Last dividend (D 0 ) = Rs 2
Growth rate for the next five years: 15%
Growth rate beyond 5 years: 10%
Assume required rate of return be 12%.
D 1 = (1 –b ) E 1 (where b is the retention rate and E 1 is the earnings per share in time 1)
When b=0 and g=0
We know that in order for an established company to grow,
it has to have a positive growth potential. In other words,
the following conditions must hold:
k > g
g – kb > 0 b ( ROE ) – kb > 0 ROE > k
P/E multiples for a share may be equated with projected growth rate in earnings. If PEG (P/E to growth ratio) is greater than one, then stock is overvalued. The basic problem with this rule of thumb is that it ignores the required rate by investor.
P/E multiple would be inverse of prime interest rate. It assumes that there is no relationship between prime interest rate and the level of corporate earnings. This assumption always does not hold good as the prime interest rate depends upon inflation rate, which also affects corporate earnings.
P/E multiple would be inverse of real rate of required by the investor. This rule protects the value of equity in face of inflation, i.e., equity income is suppose to rise in nominal terms in such a way that its real value is unimpaired.