Sunday, 15 April 2012

Value Investing - Calculating Intrinsic Value

Calculating Intrinsic Value

There are many ways to calculate the intrinsic value.  We'll just go over the most common used PE (Price to Earnings) stock valuation method to calculate the intrinsic value.   Price/earnings ratio is the most common measure of how expensive a stock is.

P/E ratio = P / EPS         P = Current Market Price,        EPS = Earnings per Share

The higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings. Companies that are currently unprofitable (that is, ones which have negative earnings) don't have a P/E ratio at all.  In general, the P/E ratio is higher for a company with a higher growth rate.Peter Lynch thinks the P/E ratio of any company that's fairly priced will equal to its growth rate.

If we know a stock  P/E ratio and its EPS, we can calculate its value by the following formula:

Value = P/E * EPS

For example, if stock ABC  long term EPS growth rate is 15%; and next year EPS estimation is \$1.8, we can suppose its next year fair PE equal to 15, and its next year’s fair value is 15 * 1.8 = 27. Now that you know what the stock is "worth", you can compare its current stock price with its value to decide if it is worth to buy, sell or hold. For example, if ABC was trading at \$20, you would consider it undervalued because its trading at a price that is less than its value of \$27. However, if it was trading at \$35 per share, it would be considered overvalued.