How to Calculate Stock Price by Using the Intrinsic Value Method
Wouldn't it be great if, by plugging some numbers into a formula, you could determine if you
should buy a stock or not? Unfortunately it's not quite that easy.
However, there are a number of calculations that you can use
to estimate the approximate value of a stock. One popular method is to calculate
a stock's "intrinsic value". Using this type of valuation method, you can calculate a stock's price
based on the expected value of future earnings per share and dividends.
When to Calculate Stock Price Using The Intrinsic Value Method
Once you've done your research and decided that you like a company and you think that the
company is positioned favorably for your investment timeframe, it's time to
decide if you should buy the stock now or if you should wait a little while for a better price.
Warren Buffett says: "it's far better to buy a wonderful company at a fair price than a fair
company at a wonderful price". In other words, decide that you like the company first, and
then figure out what price to pay for its stock.
A Few Assumptions
The method of calculation that we are about to summarize relies on making some basic assumptions about a stock
and its future direction. Before beginning the calculation, you will need to:
- Have a specific investment time horizon in mind and
- be able to estimate the future earnings per share over a specific time horizon.
Here are some assumptions for company x.
- You have an investment horizon of 10 years.
- The company's EPS (Earnings Per Share) is currently $2.50.
- You estimate that the company's EPS will grow at a steady rate of 10% per year over the next 10 years.
- The company's average PE ratio has been around 15 over the past
several years, and you expect this trend to continue into the forseeable future.
- The company has an average dividend payout of 3%.
- You would like the stock to return at least 11 percent per year.
Using this information, how do you calculate the intrinsic value of company x's stock?
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There is a basic formula that you can use. It looks like this:
Forecasted Stock Price in 2020 = Earnings Per Share after the 10th year X Average PE Ratio
This formula is actually fairly straightforward when you break it down. We're basically trying
to determine how much the company earns per share, and then multiply that amount by the amount that
investors are typically willing to pay for those earnings.
Earnings Per Share After the 10th Year = Current EPS X Rate of EPS Increase , in this case…
Earnings Per Share After the 10th Year = 2.50 X (1.10 ^10) = $6.48
This gives us an estimate of earnings per share assuming the 10 percent per year earnings
growth rate. Now we just need to plug this number into our original formula along with the
average pe ratio to get our forecasted stock price. Since we know that average historical PE
ratio is 15, we can now calculate the forecasted stock price based on the basic formula above.
In this case:
Forecasted Stock Price in 2020 = $6.48 X 15 = $97.20
So we have now determined that the stock price should be around $97.20 in 2020 if our assumptions
about future earnings are correct. Next, we also need to calculate how much the dividends will be worth.
This is an important part of the calculation, since dividends play an important part in determining a
stock's value. The formula for this is:
Dividend Payout = Total Dividends / Total Earnings Per Share WHERE
Total Dividends = Total EPS X Average Dividend Payout
Before we move on, let's define what dividend payout means. Dividend payout equals the
percentage of earnings paid out in dividends to shareholders. So if the company's earnings are
increasing over time, we can assume that its dividends are also likely to increase if it
continues to pay out a consistent percentage of its income as dividends.
So, let's go ahead and calculate the total amount of the dividends year by year for each of
the next ten years of our time horizon.
Now back to the formula. The total EPS over the 10 years in question is $43.83, and we
already know that the average dividend payout is 3.0%. Therefore:
Total Dividends = $43.83 X 3.0% = $1.32
This means that per share, the stock will have earned you around $1.32 in dividends by the
end of the 10 year time horizon. Add this to the already calculated future stock price of
$97.20 and you get $98.52.
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Now that you have the expected future stock price, or future value, of the stock, you can
calculate the net present value, a.k.a. intrinsic value, using this formula:
Net Present Value = Future Value / Expected ROI
= $98.52 / (1.10 ^ 10)
= $98.52 / 2.59 = $37.98
Now compare the calculated net present value to the current stock price. Since the calculated
intrinsic value of $37.98 is more than the current share price of $30.00, it would seem that
you should just go ahead and buy the stock now, right? Actually, many people would say
that you should take one more step before you pull the trigger and buy.
Margin of Safety
On top of calculating the intrinsic value of the stock, many value investors typically look
for what Warren Buffett calls the margin of safety. Margin of safety is the percentage
difference between the calculated intrinsic value and the current stock price.
if you find that the intrinsic value of a stock is $50 and the actual stock price is $40, the
stock is trading at a 20% discount to its intrinsic value of $50, since $40 is 20% less than $50.
In this case, the margin of safety is 20%. It should also make sense that, the higher the
margin of safety, the "safer" the investment is likely to be and the less potential downside
it is likely to have.
So now you know how to calculate a stock's intrinsic value based on expected future earnings and dividends.
Consistently using this method or other similar valuation methods can help you to estimate the value of
stocks and therefore can help you become a better investor.
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