Contents
- Index
Overview
©2009 OS Financial Trading System
What is Intrinsic Value of a stock?
We define the intrinsic value of a firm's stock as the present value of future economic dividends discounted back at the firm's cost of equity capital. Formally, an economic dividend is the dividend that could be paid by a stock over some period of time without affecting the beginning period value of the stock. In other words, in classical finance theory it does not really matter whether or not a stock actually pays dividends when assessing it's intrinsic value. Google, provides a dramatic example of this point which has also been demonstrated analytically by Modigliani and Miller.
The two major decisions that affect the intrinsic value of a stock are the investment and financing decisions. The latter impacts the discount rate -- the cost of equity capital and the former can influence both the numerator (economic dividends) as well as the discount rate. In these projects we will take these two major firm decisions as given and focus on the problem of estimating both the numerator (economic dividends) and the denominator (cost of equity capital) to assess the intrinsic value of a stock. Operationally, we do this by starting with the firm's basic set of financial statements: Income Statement, Balance Sheet and Cash Flow statements. By placing a different emphasis upon each of these three statements leads to three analytically equivalent approaches to estimating the intrinsic value of a stock. These three approaches result in three different models: The Free Cash Flow Model, the Residual Income or Earnings Model and the Abnormal Earnings Growth Model. Each of the models are applied by emphasizing different financial statements under the assumption that the firm is a going concern.
A fourth model is also introduced to cover the case for valuing a stock where the going concern assumption is not valid. This model is Merton's distressed firm model which applies option pricing theory. Each of these models is covered by the FTS Real Time Client's analytical support system. The following projects demonstrate how to apply this powerful support system to the real worlds.
Valuation Models
Free Cash Flow to Equity Model
Residual Earnings Model
Abnormal Earnings Growth Model
Distressed Firm Model