Intrinsic Value Calculation

Ever wonder how did the analysts come up with a target price for the stocks that they cover? Do you understand the inputs that they use in their report? eg.) WACC, FCFF, FCFE, g, r, d.. etc

As promoised, i shall talk about 3 methods of intrinsic value calculation commonly used by research analyst.

  1. Dividend Discount Model (DDM)
  2. Free Cash Flow to Firm/Free Cash Flow to Equity (FCFF/FCFE)
  3. Residual Income Model

NOTE: Remember to pay special attention to the inputs of the formula or you will end up in a state whereby “rubbish IN = rubbish OUT“.

Dividend Discount Model (DDM)

This model is commonly used because of its simplicity and it is easily understood. The whole concept behind this model is to discount the dividend that you expect to receive in the future to their present value (since $1 to be receive in 1 yr time will be worth lesser than $1 now, hence we need to discount this value by a discount rate, r). Major drawbacks of this model include heavy weightage being placed on the terminal value (ending value after X no. of years) and the dividend growth rate has to be a constant figure, ie to say the dividend has to be growing at the same rate or the formula will not be accurate.

The formula looks like this: IV = D1/(r – g)

where IV = intrinsic value, D1 = Dividend in the next period or D*(1+g), r = discount rate, g = constant dividend growth rate.

Free Cash Flow to Firm/Equity

For this 2nd model, it works the same way as the DDM illustrated above. The only difference is that instead of discounting the future dividends to the present value, you should be discounting the future free cash flows to their present values. Dividend is pretty straight forward as it can be easily found in the annual report. As for FCFF and FCFE, you might need to do abit of calculation if they are not presented in the AR.

Here’s the breakdown for FCFF/E:

FCFF = NI + Ncc + Int(1-tax) – NWC – FcInv

FCFE = FCFF – Int(1-tax) + net borrowing

where NI = net income, Ncc = non cash charges (eg. depreciation/amortization), NWC = net change in working capital (current asset excluding cash – current liability excluding ST borrowings)

Int(1-tax) = interest payable to bondholders after tax is added back since this amt is available to bondholders

FcInv = fix capital investment (ending gross PP&E – beginning gross PP&E)

Once you have the figure for FCFF/E, simply plug the figure into the formula below:

IV = FCFF1/(WACC – g)            or          = FCFE1/(r – g)

where WACC = weight average cost of capital (cost of capital at the company level)  or click –> Here for the formula

r = rate of return required by the equity holders

Residual Income Model (Most important and useful formula of all)

Residual Income Model is one of the most accurate way to calculate the intrinsic value of a company  as it is relatively less sensitive to the terminal value estimate (the case for DDM) and it places heavy emphasis on the current book value. This greatly reduces the forecasting errors involved as book value is a figure that can be found under the balance sheet reported in the Annual Report.

IV = B + [(ROE – r)*B/(r – g)]

where ROE = return of equity = (NI/Sales)*(Sales/Asset)*(Asset/Equity) = NI/Equity, B = current book value

Try calculating the intrinsic values of the companies in your portfolio and check against the margin of safety today! Did you overpay for your stocks???

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