Friday, March 11, 2016

How to Calculate Intrinsic Value

In order to buy at an undervalued price, you’d first have to know what the fair price is. This combines art and science. The science is that given perfect company estimates and your target rate of return, you can easily calculate the objective fair value of any business or asset that produces cash flow. The art is that of course you don’t have the perfect estimates, you only have your imperfect approximations. You can make estimates based on historical growth rates, or based on future trends that could shape those growth rates, based on analysis of how the company is spending its cash, or based on realistic management projections and a pattern of meeting those projections.

Discounted Cash Flow Analysis (DCFA) is the fundamental stock valuation methodfor any asset or business that produces cash flows. When this method is applied on a share-by-share basis of a dividend stock, then it’s called either the Dividend Discount Model or Method (generally), or the Gordon Growth Model (under expectations of a perpetual static growth rate).
DCFA and the associated DDM produce perfect fair values given perfect inputs, although of course you’re always going to have imperfect inputs. And the longer the actual stock price remains under the calculated fair value, the better it is for an investor assuming that you’re reinvesting dividends, buying more shares, or the company is repurchasing its own shares.
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