Issue 112, 20 September 2002
Investor's College Investment equation pt 4 This is the final part in our series and perhaps the most interesting - a case study on calculating intrinsic value. After explaining the concept of discounting cash flows, we've had a few subscribers request a case study. That's a great idea, so here it is. We've picked what we thought was a fairly straightforward company to analyse, Australian Stock Exchange. In our view it's likely to produce long-term (10-year) profit growth and therefore dividend growth of, conservatively, 6% a year. Now, to apply the principles we've covered, we first take the fully-franked dividend for 2002 of 40.6 cents and adjust it for the franking credits (see issue 103/May 02). This gives us a 'grossed-up' (or pre-tax) dividend of 58 cents. That's our starting point. Discount rate Now we need to select a suitable discount rate. As we mentioned last issue, Buffett says he uses the long-term government bond rate, unless rates are unusually low. We believe current rates fall into this category so we'll use 7% as our discount rate. The first part of the equation is pretty straightforward. We take the 58 cents for this year and multiply it by 1.06 (100% plus 6%, our assumed growth rate). The resulting 61.5 cents becomes our first cash flow to discount. We then use the formula shown in issue 110 to figure out how much that 61.5 cents we expect to receive in one year is worth in today's dollars. For those who don't remember, the formula is: PV = FV/(1+r)n So applying the figures we've discussed, the equation becomes: PV = 61.5/(1.07)1 < /p > That works out at 57.5 cents. Then we repeat this process. For year two, the projected dividend would be 65.2 cents. The present value would be: PV = 65.2/(1.07)2 That's five cents less than the first year â&#x20AC;&#x201C; 57 cents. That's all you need to do. It's simply a matter of continuing this process over and over again until, at some point, say 10 years, you can make an assumption about the likely range of the share price. Now, if you do the maths, you'll find that at a 6% growth rate, the dividend in 10 years time will be about $1.04. Now, if the stock is trading on a dividend yield of 3% then the price is likely to be $34.67. If it's on a yield of 5% then, using our assumptions, the price will be $20.80. The next step is to apply the discounting formula to figure out how much those prices equate to in today's dollars. First: PV = 34.67/(1.07)1 0 That's $17.62. Second: PV = $20.80/(1.07)1 0 < /p >
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That comes to $10.57. So, if you add the present value of the dividends for the next 10 years to the discounted value of the projected share price range, you will come up with the intrinsic value range. But, before you run off and begin applying this procedure willy-nilly, bear a few things in mind. Some businesses, by their nature, will be easier than others to apply this methodology to. And, before doing it you really need to understand the business and be confident of its long-term outlook. Obviously the Australian Stock Exchange is an easier stock to value than, say, News Corp. And stocks like Peptech and Chemeq (which we don't cover but seems to be dangerously 'hot' at the moment) are all but impossible to value on this basis. Also, if you go ahead and work through the maths you'll notice that a few key variables will have a big impact on the intrinsic value. The discount rate is the first one. Assumptions And the value at the end of the period is also crucial. So the assumptions you make about it are very important. In our example, that's the dividend yield the stock is likely to trade on. You should also remember an important acronym - GIGO, or garbage in, garbage out. In other words, if your analysis is based on incorrect assumptions, then the value of the mathematics will be zero or worse. But if you have logical assumptions and are confident about your predictions then you can rely on your discounted cash flow valuation as a good guide to the intrinsic value of a stock. You can then ascertain the discount or premium the stock is trading at in relation to your estimate of intrinsic value. This makes comparisons between stocks easier â&#x20AC;&#x201C; simply buy the one you feel is trading at the biggest discount to intrinsic value
C o p y r i g h t Š 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.
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