Intrinsic value is the actual value of a company. In order to venture into a profitable stage, it is important to understand the intrinsic value of a company. It is the true value of a business including all aspects of tangible and intangible assets.
There are a number of methods through which an investor can calculate the intrinsic value of shares. Dividend discount model or Gordon growth model is an easy way to do so.
Dividend discount model
The model is based on the assumption of dividend payments in the present and future. Thus, it calculates the present value of the future dividend payments. In order to calculate the intrinsic value through this method, the investor needs to make some assumptions, such as:
- Discount rate that will apply in the future, this would give the present value of future cash flows.
- Changes in the dividend in the future.
- Time period for which the company will continue making payments.
The following table shows the calculation of the intrinsic value of shares.
| Year | Dividend | Discount Factor | Present Value |
| 2017 | .60 | 1.00 | 0.6 |
| 2018 | .60 | 1.10 | 0.55 |
| 2019 | .60 | 1.21 | 0.50 |
| 2020 | .60 | 1.33 | 0.45 |
| 2021 | .60 | 1.46 | 0.41 |
| 2022 | .60 | 1.61 | 0.37 |
| 2023 | .60 | 1.77 | 0.34 |
| Intrinsic Value | 3.21 |
Discount rate = 10%
Dividend growth rate = 0%
Intrinsic value = 3.21
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The present value is calculated by dividing the dividend by discount factor. The dividend growth in the above example is assumed to be zero percent, but depending on the market dynamics, a suitable growth rate could be assumed.
The intrinsic value is the sum of all present value. Different scenarios could be built based on different assumptions, primarily inclined towards the future market growth.
The limitation of the model is that it is sensitive to the assumptions. In the above scenario the dividend growth is assumed to be zero but in the real circumstances, there would either be growth or decline in the dividend growth rate. This is difficult to predict as the stock exchange dynamics are extremely volatile. However, based on the assumptions, it is a good indicator of whether the intrinsic value is close to the present market value.
Alternatively, depending on the discount rate assumed, the present value of the stock could be calculated. The above scenario gives the intrinsic value of the stock; discounted rate could further be used to calculate the future stock value through Gordon’s equation.
Gordon’s Equation P = D (1) / (r – g)
Where,
P = Price of stock
D (1) = Estimated value of next year’s dividend
r = Cost of equity
g = Growth of dividends
Scenario
Company X paid a dividend of $2 per share this year. The expected dividend growth rate is assumed to be 5% per year. The companies cost of equity is 7%.
Step one is to adjust the current year dividend by its growth rate to calculate the value of D1.
D1 = D (0) X (1+5%) = 2 X (1.05) = 2.1 (The method is similar to the dividend calculation in the above table)
The future price of the share can now be calculated, using the estimated value of next year dividend.
P = D1 (2.1) / (r (7%) – g (5%)) = 105
| Year | Dividend | Discount Factor | Present Value | Dividend (D x)[discount rate = 10%] | Price of Stock |
| 2017 | .60 | 1.00 | 0.6 | 30 | |
| 2018 | .60 | 1.10 | 0.55 | 0.66 | 33 |
| 2019 | .60 | 1.21 | 0.50 | 0.73 | 36 |
| 2020 | .60 | 1.33 | 0.45 | 0.80 | 40 |
| 2021 | .60 | 1.46 | 0.41 | 0.88 | 44 |
| 2022 | .60 | 1.61 | 0.37 | 0.97 | 48 |
| 2023 | .60 | 1.77 | 0.34 | 1.06 | 53 |
| Intrinsic value | 3.21 |
In the above case we have assumed a definite dividend growth rate to give more precision to the model.
Limitations of the model
The model is a reasonable way of calculating future stock price from the perspective of investment decision; however, there are limitations to this model, such as:
- The model assumes that the dividend growth is constant, but the share market is dynamic and so is the company. Based on the changing circumstances, the dividend distributed by the business may fluctuate from time to time.
- Second limitation is that the price of the stock is based on the formula, which, in turn, is based on the inputs like discount rate and cost of equity. Any deviations to the same would result in fluctuating values.
The above estimates and calculations are based on assumptions, considering the dynamic stock exchange environment, it is always advisable not to use these methods in unison. These calculations should be combined with the other factors in order to take the correct investment decision. Failing to do so would result in erroneous conclusions, which would lead to unreasonable decisions, thereby resulting in losses.
