Contents
- Index
Assessing Intrinsic Value: Key Concepts
©2009 OS Financial Trading System
Concept 1 (Normal Earnings): The firm's normal earnings is defined as earnings that are due to growth at the investors' required rate of return. This is defined as:
Normal Earningst = Cost of Equity Capital * Earningst-1
Concept 2 (Abnormal Earnings Growth): This concept is designed to capture the value added from anticipated earnings growth. It is defined as the difference between Cum-dividend earnings and Normal Earnings. This is defined as follows:
Abnormal earnings growtht = Cum-dividend earningst - Normal earningst
Cum-dividend earnings = Comprehensive Earnings + Cost of Equity Capital*Accounting Dividendt-1
To project residual earnings into the future the second important input for this concept is assessed growth behavior of earnings. This allows earnings to be projected out over time by growing at the assessed growth rates.
Concept 3 (Cost of Capital): The discount rate used to compute the present value of future residual earnings per share is the stock's cost of equity capital. The firm's financing decision provides one driver of this discount rate in addition to capital market constraints. Combined the cost of equity capital equals the return required by investors in the capital markets.
Next we will apply the above concepts to assess the intrinsic value of IBM.