Sunday, 15 April 2012

How to Calculate Intrinsic Value for Stock Investing

How to Calculate Intrinsic Value
Discounted Earnings, Instead of Just Cash Flow

Summarized Overview

You will find information about why you should calculate intrinsic value in stock market investing, and step by step guide on how to do it.
You will also find information about which key financial ratios to use and what you have to do after calculating intrinsic value.

Why You should Calculate Intrinsic Value

Simply because, you don't buy any stock at any price, do you? Do you know why? Because you want as much return as possible!
The price you are paying is the ultimate determinant for the rate of return that you'll be earning. The higher the price you pay for it, you'll be getting lower rate of return. This is why, you need to know how much a stock worth. Once you know its value, you can identify which stocks are traded at discounted price.
However, buying a stock simply because it is cheap is not the right approach either. This is another reason to calculate intrinsic value. To buy quality stocks at discounted price, value for money right?

How to Calculate Intrinsic Value

The way to go is, search for stocks whose prospects you believe in ( with good stock pick method ) and then use a valuation technique to ensure the purchase price is acceptable. Here, I use net present value (NPV) formula.
How to do it? Let say you are valuing stock ABC,
Case Study to calculate Intrinsic Value
From 13 years historical data, you get the information as above. To proceed, you also need to firm up your expectation based on your risk profile. In this example:

  • I set my investment horizon as long as ten years from 2007. So that in 2018 I can use the fund to finance my children's study
  • I am confident stock ABC will continue growing 13 per cent per year for the next ten years (13 years records prove this stock able to grow 13 per cent EPS per year)
  • I assume stock ABC will be having the same PER and dividend payout by end of 2017 (or early in 2018)

  • I am expecting 12 per cent return on investment (ROI) so that my initial investment able to cover my children's tuition costs in ten years time.

  • Let's start calculating intrinsic value of stock ABC.
    Step One: Forecast Share Price

    First of all, you need to forecast its share price ten years down the road. In this case, I project the price for the next ten years using 13 per cent per year growth.
    Step Two: Forecast Total Future Value

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


    Future Value 2018
    Look, some investors doesn't care much about dividend. To them, dividend is just too small to be considered. But as it has effect to the total future value, it should be taken into consideration.
    By the end of the day, you can compare the stock's profitability to others; which may not pay any dividend at all.
    Step Three: Calculate Intrinsic Value

    After having all these data, then only you can calculate the intrinsic value for stock ABC.
    Intrinsic Value stock ABC
    Step Four: Compare with Current Stock Price

    The intrinsic value above is because my goal is to get 12 per cent per annum from this stock. If so, current stock's price, which is $33.50, is acceptable indeed (stock price is below the intrinsic value).
    How Do You
    Intrinsic Value?

    Discounted Cashflow
    Discounted Dividend
    Discounted Earnings
    Never Calculate
    What For?
    But if your goal is about getting 25 per cent per annum return on investment, the intrinsic value will be $22. In this case, the current stock price will no longer acceptable for you.
    For this same reason, you can say that current stock price is suit to those who are aiming for 15 per cent return per annum (in economics, this called as Internal Rate of Return or IRR)

    What's Next?

    As you can see, 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 may as well better keep the cash in fixed deposit.
    As an investor, it is crucial to set a realistic target on the expected profits.

    It is better if before you calculate intrinsic value of your selected stock, assess your own risk profile first. This will help you to determine your realistic preferred return based on your need, ability and investing habits.
    Eager to buy stock? Hang on first! You need to have the fair value as another comparison. This is what mention by Warren Buffet's guru, the margin of safety

    Related Reading

    How to Value Stock - 3 Methods Warren Buffet Wants You to Learn
    If you are looking for ways on how to value stock, click here. I'll share with you 3 stock valuation model most commonly used by stock analyst.

    Additional Reading

    How to Determine Margin of Safety in Stock Investing
    Margin of safety is a way to preserve capital. Find out how to determine fair value for each stock effectively.
    Guide in Analyzing Company for Stock Investing
    Four guidelines in analyzing company that you are about to invest in. Find how companies difference to each other.
    Fundamental Analysis: Definition and Basic Guide for Beginners
    Fundamental analysis is a practice that attempt to determine stocks’ valuation. This technique is focusing on the underlying factors that affect the company’s actual business performance.
    Unlimited Profits From Good Stock Pick
    Discover my simple but profitable stock screening criteria. It is proven to be a good stock pick strategy for all stock investors.

    Related Books

    Security Analysis
    Security Analysis is the bible of fundamental analysis. Originally published in 1934, the tome systematically lays bare the science of security analysis.
    Value Investing: From Graham to Buffett and Beyond (Wiley Finance)
    Discusses where to look for underpriced securities, how to determine the intrinsic value of a stock, and alternative methods for constructing a portfolio that control risk without restricting investment return.
    The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)
    Among the library of investment books promising no-fail strategies for riches, Benjamin Graham's classic, The Intelligent Investor, offers no guarantees or gimmicks but overflows with the wisdom at the core of all good portfolio management.

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