Contents - Index

Assessing Intrinsic Value:  Key Concepts
©2009 OS Financial Trading System


Consider the three major sets of decisions that determine the intrinsic value of a stock.  These are:  Investment Decisions, Financing Decisions and Dividend Decisions.  We define intrinsic value of a stock as the present value of future (economic) dividends discounted by the stock's cost of equity capital.  In the FCFE model for assessing intrinsic value there are three major inputs.  These are:  Economic Dividends, Future Growth Behavior and the Discount Rate which we refer to as the Cost of Equity Capital.
Concept 1 (Economic Dividends):  The investment decisions drive current and future cash flows.  We can break up these cash flows into two important components.  The first, is cash that is required to sustain the value of the firm's investment decisions and the second is cash that can be distributed by the firm without affecting the firm's value.  The latter component we will refer to as "Free Cash Flow (FCF)."   The former we will refer to as "Capital Expenditure."  The relationship is captured in the following definition:
Free Cash Flow = Cash Flow from Operations - Capital Expenditures (CAPEX)
To value a stock, however, we only care about the Free Cash Flow to Equity (FCFE).  This second measure recognizes that when the financing decision involves both debt and equity then some of the Capital Expenditures is funded by Debt-holders.  As a result FCFE > FCF for a firm that has debt and equity.
Concept 2 (Growth Behavior):  To project free cash flows into the future we need to assess the firm's growth behavior.  We will consider this behavior in two stages.  In stage 1 we will consider abnormal growth behavior which can be large and in stage 2 we will consider normal growth behavior which is constrained by how much the economy as a whole is expected to grow.
Concept 3 (Cost of Capital):  The discount rate used to compute the present value of future free cash flows from a stock is referred to as the cost of equity capital.  The most common method for estimating this input is to apply the capital asset pricing model (CAPM).
Next we will apply the above concepts to assess the intrinsic value of IBM.