If you’ve read any of the articles on this website – or if you’re familiar with value investing concepts – then you may know that an Intelligent Investor will only buy a stock when its market value (that is, its stock price) is less than its intrinsic value.
In other words, a smart investment is one where you are buying a stock for less than its intrinsic value.
But what exactly is intrinsic value and how do you calculate it?
Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
Viewing a Business as a Bond
What does Buffett mean by this? Imagine a bond, for instance, which pays the bondholder interest every year and principal back at maturity. From Value Investing 101: The Time Value of Money, we know that a dollar today is worth more than a dollar tomorrow, and vice versa that a dollar tomorrow is worth less than a dollar today. Therefore, the interest and principal payments we receive in the future must be discounted to a lower value in order to determine their value today.
So, the present value of a bond = the discounted value of the bond’s future interest and principal payments. (If this doesn’t make sense, then please read my Time Value of Money article before reading on).
Now picture a company.
What is the purpose of a company? Answer: To generate dividends for the company’s shareholders.
This is a lot like a bond isn’t it? Except instead of being paid interest every quarter, a shareholder is paid dividends every quarter. This means you can discount the value of future dividends just the same way that you can calculate a bond’s future interest and principal payments.
Remember that the present value of a future payment = the future value of the payments, discounted at a certain rate?
In math form, this equation is the following (where i = the discount rate):
If the future payments will growth at a constant rate, then the equation can be simplified as:
The above equation is called the Dividend Discount Model (or the Gordon Growth Model) and its output is the intrinsic value of a stock.
Limitations of the Dividend Discount Model
“But,” you might argue, “not all stocks pay dividends, and even the ones that do pay dividends don’t have a consistent dividend growth rate.”
You’re right, of course. Unlike with a bond, a company doesn’t have any contractual obligations to pay a dividend to its shareholders.
Furthermore, dividends alone don’t capture all of a company’s earnings. Besides paying a dividend, a business can also use the cash it generates to acquire new equipment or machines, to improve its factories or buildings, for research & development, to acquire another company, or to make other investments.
Any of these can be a better allocation of capital than if the company had paid a dividend. So while the dividend growth model (DDM) provides a good framework to understand intrinsic value, it doesn’t actually generate a realistic result.
Next Up: DCF and Owner Earnings
In Part 2, we’ll take the DDM one step further and will use a Discounted Cash Flow analysis to calculate a more accurate intrinsic value of a stock.
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