Saturday, 10 March 2012

The four basic factors needed to appraise the intrinsic value of an operating enterprise and thus its common stock equity

An important distinction is the difference between reported accounting value (book value or net worth per share) and intrinsic economic value (discounted future dividends per share).

  • Book value does not reflect inflation and obsolescence, nor does it include intangible assets such as "franchises" and technological prowess resulting from R&D expenditures. 
  • In addition, book value per share is merely a mechanical screening ratio set at an arbitrary cutoff point which does not reflect judgment and does not reliably distinguish between underpriced bargain stocks and fairly-priced junk stocks.

Intrinsic economic value of an operating enterprise is appraised by use of discounted cash flow techniques in the so-called dividend discount model originated by John Burr Williams.

  • He made allowance for both dividends and future selling price. 
  • He also explains how the transposed dividend discount model can be used to determine what the market as a whole is expecting, and this can be compared with the investor's expectation.

As John Burr Williams (1938: page 466) wrote: "in other words, Investment Analysis usually measures the relative rather than the absolute value of any stock, and leaves to the economist the broad question of whether stocks in general are selling too high or too low. ... From the point of view of this book, which is concerned with absolute rather than relative value, ... "

According to Williams (1938), the four basic factors needed to appraise the intrinsic value of an operating enterprise and thus its common stock equity, two economy-wide factors and two company-specific factors. The economy-wide factors are general price level inflation and the real interest rate. The company-specific factors are the estimated future net cash distributions to the stockholders and the discount rate or rates applied to those cash receipts. For foreign companies, a fifth factor may be required: the currency exchange rate, which is discussed at length by Williams (1954). This is important enough to justify a table to repeat it for emphasis.
Factors of Intrinsic Economic Value
general price level inflation rate
real interest rate
dividends or free cash flows to equity
discount rate or rates
currency exchange rate, where applicable

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