Contents
- Index
Intrinsic Value: Key Concepts
©2009 OS Financial Trading System
Concept 1 (Book Value per Share): The firm's investment and dividend decisions determine the book value per share. The book value per share represents the shareholders' investment in the firm. Book value per share is simply value of the owners equity divided by the net shares (i.e., shares issued less Treasury stock) outstanding.
Concept 2 (Future Residual Earnings Stream): This concept is designed to capture the value added to book value per share that results from assessing the firm's investment and financing decisions. Residual Earnings at time t is defined as Comprehensive Earnings at time t - Investors' Required Rate of Return (= Cost of Equity Capital) * Beginning period book value.
Note: Residual Earnings is based upon the clean surplus accounting using "Comprehensive Income" which attempts to measure the total of all operating and financial events that have changed the shareholders' equity over the period.
To project residual earnings into the future the second important input for this concept is assessed growth behavior of the book value per share. This allows residual income to be projected out over time by growing at the assessed growth rates. Under these projections if residual earnings are expected to be positive over time then intrinsic value will exceed book value and vice versa.
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.