Intrinsic Valuation Approach¶
The intrinsic value of equity stock is a critical concept in finance, used to determine what a stock is truly worth based on its expected future cash flows. This value is calculated using various models, of which the Dividend Discount Model and the Earnings Capitalization Model are the most prominent.
Dividend Discount Model (DDM)¶
The Dividend Discount Model values an equity share based on the present value of its future stream of dividends. This model assumes that the value of a share is derived from the cash flows (dividends) expected to be received by the investors and the risk associated with receiving these cash flows.
Basic Dividend Capitalization Model¶
This foundational approach is ideal when an investor plans to hold a share for a specific period and then sell it. The value of the share under this model is calculated as follows:
Formula for One Period Valuation¶
\(P0 = [D1 / (1 + ke)] + [P1 / (1 + ke)]\)
P0: Value of the share today.D1: Expected dividend at the end of the first year.P1: Expected price of the share at the end of the first year.ke: Required rate of return.
Example: Mr. Vinod plans to buy a share, hold it for one year, and then sell it. The expected dividend at the end of year 1 is Rs.7, and the expected sale price is Rs.200 after the first year. Assuming the discount rate is 15%, the value of the share today would be calculated as follows:
\(P0 = [7 / (1 + 0.15)] + [200 / (1 + 0.15)] = 6.09 + 173.91 = Rs.180\)
Two Period Valuation¶
If an investor plans to hold the share for two years, the value can be calculated by extending the one-period model:
Formula¶
\(P0 = [D1 / (1 + ke)] + [D2 / (1 + ke)^2] + [P2 / (1 + ke)^2]\)
D2: Expected dividend at the end of the second year.P2: Expected selling price of the share after two years.
Example: An investor expects to receive dividends of Rs.7 and Rs.7.50 in the first and second years, respectively, and plans to sell the share for Rs.220 at the end of the second year. If the required rate of return is 15%, the value today would be:
\(P0 = [7 / (1.15)] + [7.50 / (1.15)^2] + [220 / (1.15)^2] = 6.09 + 5.67 + 166.25 = Rs.178\)
Earnings Capitalization Model¶
This model is used to estimate the value of a share based on the capitalization of its expected earnings, rather than dividends. It is particularly useful for companies that do not pay dividends.
Multi-Period or N-Period Valuation¶
For investments intended to be held for multiple years, the DDM can be extended to accommodate longer periods:
Formula¶
\(P0 = Σ [Dt / (1 + ke)^t] + [Pn / (1 + ke)^n]\)
Where:
- Dt: Dividend expected at the end of year t.
- Pn: Expected selling price after n years.
This formula is particularly useful for understanding long-term investments and their intrinsic value based on projected earnings and market conditions.
Conclusion¶
Understanding the intrinsic value of shares through these models allows investors to make informed decisions based on the present value of expected future benefits, adjusted for risk and time, thereby aligning investment strategies with personal financial goals.
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