This post was originally published in the Feb’21 edition of FPSB Journal for Certified Financial Planners

By Srikrishna, CFP^CM

Understanding the basic concept of value investing is simple. Buy a stock when its price is less than its intrinsic value, and hold it for the long term. Intrinsic Value, also known as fundamental value, is the price that an investor who is fully aware of its characteristics would pay for the stock.

But, how do we actually determine this intrinsic value of a stock?

That was the first and the most important question I faced after reading all the popular books and articles on value investing out there.

In this article, I have tried to explain the three popular equity (stock) valuation models, how and when to use them, and their various shortcomings. These are the Discounted Cash Flow (DCF) Model, the Multiplier Model and the Asset Based Model.

Before we do that, here is a list of assumptions that must work in our favour for any of these valuation models to work:

• Some stock prices vary significantly from their fundamental value
• This mispricing is not an indication of some underlying characteristics of which we are unaware
• We are confident in the quality of the estimated inputs used
• We believe that the price will move towards the fundamental value within our investment time horizon

DCF Model

In the DCF model, the intrinsic value of a stock is the present value of cash flows expected from the stock (dividends / free cash flow to equity – FCFE) discounted at the required rate of return. FCFE is the cash available after the firm meets its capex and other obligations. Also, free cash flow to equity can be used when the dividend payment estimates are uncertain, and earnings growth rate can be reasonably predicted.

Example: Vedanta Ltd. is currently trading at Rs.144 and has recently declared a dividend of Rs.18 per share. It has been paying dividends consistently over the past few years and we assume that the company is going to pay dividends for at least the next five years. Our required rate of return from equities is, say, 10% per annum.

Case 1 : The dividend is expected to grow by 5% per annum and five years later the stock price will be around Rs.230. 

The discounted present value of the stock arrived at by using the DCF Model is Rs.221, but the stock is currently trading at Rs.144, which suggests that the stock is undervalued. 

Case 2: The dividend of Rs.18 is expected to grow constantly at 5% per annum. 

Intrinsic value of the stock = (next year’s dividend) / (required return – growth rate) i.e. (18.90) / (0.10 – 0.05) = Rs.378

Readers may note that this formula will not work if the dividend growth rate is higher than our required rate of return.

Case 3: The dividend of Rs.18 is expected to be paid indefinitely and you do not wish to sell the stock.

Intrinsic value = dividend amount / required rate of return i.e. (18/0.1) = Rs.180

If we are not sure of the firm’s dividend paying capacity, we can replace dividends with FCFE per share and other calculations remain the same. We can also combine these formulas for a company that might experience extremely high growth rate at first, and then slow down to a constant percentage.

Limitations: This model is highly dependent on the quality of inputs and is also sensitive to changes in the estimates.

Multiplier Model

In this model, the valuation is determined by either a ratio of price to some fundamental metric or a ratio of enterprise value-to-EBITDA or revenue. The most common ratios are price-to-earnings, price-to-sales, price-to-cash flow and price-to-book value. Enterprise value is simply the cost of acquiring the company as a whole today (i.e. the market value of its stock and debt minus its cash and short-term investments). 

This multiple is then compared to the historical averages of the same stock, or with stocks of the peer group / industry averages.

Example: ITC, at a market price of Rs.213, has a P/E multiple of 17.39x. This effectively means that we are paying Rs.17 for every Rs.1 of the company’s earnings. Now let’s assume that ITC’s historical P/E is around 18 and its competitors have an average P/E of 19. By this we may reasonably conclude that ITC is slightly undervalued.

Limitations: In this model, the ratios must be compared to either peer group companies or to an industry average, which means these ratio are dependent on the availability of peer group data / comparable firms. Even accounting methods must be similar across companies for the comparisons to work. Also, the multiplier approach may be inappropriate for cyclical firms.

Asset-Based Model

In this approach, the intrinsic value of a stock is calculated as the total asset value less liabilities and preferred stock, as per the numbers reflected in the company’s balance sheet. This approach is best suited for private companies with tangible assets or assets whose market values are readily available.  

Example: If a company X has assets of Rs.1000 million, liabilities of Rs.500 million and 1 million outstanding shares, then the intrinsic value per share can be calculated as (assets – liabilities) / (number of outstanding shares) i.e. (1000 – 500) / (1) = Rs.500.

Limitations: Most often the book values do not reflect the actual value. Also, this model cannot be used when the firm has a high proportion of intangible assets.

Summary

It is always better to use multiple models with different inputs and come up with a range of possible values rather than a precise estimate. These methods can be interesting to learn. But, as is the case with everything in life, only skill and experience gained through years of trial and error can help you judge the actual intrinsic value. 

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