Why Calculate Intrinsic Values?

Analysts and investors calculate intrinsic values for an important reason, they identify under-priced stocks. If an investor calculates an intrinsic value of $300 for a stock, and it is trading on the market for $250, it will be perceived as a bargain price and a good investment.

The Dividend Discount Method

The dividend discount method (DDM) is a quick and easy way to evaluate intrinsic value. It is especially useful for large, stable companies. The commonly used formula for the Gordon Growth version of the DDM is focused on dividends, which are cash paid to stock holders and their future growth. It is:

Intrinsic Price of Stock = DPS1 / (r - g)

where:

DPS1 = Expected dividends one year from the present

r = The discount rate or required rate of return on the investment

g = The annual growth rate of dividends in perpetuity

For instance, Mountain Energy Company is an established public utility with a stable customer base. It expects to pay a $15 dividend per share this year, which has had a stable 3% growth over the years. We will use 3% for g in the formula. The required rate of return for this type of investment is 8%, which is r in the formula. The intrinsic value of Mountain Energy Companys shares is:

$15 / (.08 - .03) = $300

The Discounted Cash Flow Method

The most widely used method for getting at intrinsic value is the discounted cash flow (DCF) method. It uses free cash flows rather than dividends to come up with a value. This method is also very flexible in that it allows for cash flow estimates to vary from year to year and works for any size company!

Lets go through a simple example step-by-step. Cy Cycles carries a full line of road and mountain bikes. Cy and his partners have two very successful retail locations and plan an aggressive expansion over the next five years. They want to issue 3,000 shares of stock to investors and family members who will put down their money and make the growth possible. Cy and his partners are interested in estimating the intrinsic value of these shares. Beth is the partner who is the wizard of finance for the business! She and Cy are going to go through the steps to find out.

Bikes for sale
Bikes

1. Project free cash flow for the forecast years. Cy expects to have $10,000 in free cash flow for the current year. He expects that cash flows will grow by 20% each year for next five years.

2. Come up with a discount rate. The number to focus on is assumed cost of equity. Beth tells Cy she will use 8%.

3. Discount the projected free cash flows to present value. Beth has worked up a table that shows the estimated cash flows discounted for the first five years. Here it is:

Year Cash Flow Discount Calculation PV of Cash Flow
1. $10,000 $10,000 / 1.08 $9,259
2. $12,000 $12,000 / 1.08^2 $10,288
3. $14,400 $14,400 / 1.08^3 $11,431
4. $17,280 $17,280 / 1.08 ^4 $12,701
5. $20,736 $20,736 / 1.08 ^5 $14,113

The sum of the discounted cash flow is $57,792.

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