Sunday, August 22, 2010

More on Valuation - Intrinsic Worth

How much are stocks worth? They are worth the present value of their future cash flow. That value is determined by the amount , timing and riskiness of the cash flows.

To calculate the intrinsic worth of a stock, some concepts are needed. First, the discount rate (R) which equal to the time value of money plus a risk premium. The risk premium is tied to factors like size, financial health, cyclicality and competitive positioning of the firm under evaluation. Finally, there is a very long term estimated growth rate of cash flow (g).

To calculate the intrinsic worth, follow five steps:

1) Forcast free cash flo (FCF) for the next 10 years

2) Discount these FCFs to reflect the present value
     Discounted FCF = FCF for that year / (1+R)^n
     (where R is the discounted rate and n is the year
     being discounted)

3) Calculate the perpetuity value and discount it to the present
     Perpetuity Value= FCF(n) * (1 +g) / (R - g)
     Discounted Perpetuity Value = Perpetuity Value /
     (1 + R)^n

4) Calculate total equity value by adding the discounted perpetuity value
     to the sum of the 10 discounted cash flows in step 2
     Total Equity Value = Discounted Perpetuity Value + 10 Discounted Cash

5) Calculate per share value by dividing total equity value
     by shares outstanding
     Per Share Value = Total Equity Value / Shares Outstanding

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