That is why I argue that most investors out there do not need a complex “discounted cash flow Intrinsic Value calculation”. Yes it will give you a more precise answer, but a much easier valuation technique can give you the same answer within 5 minutes. Here is what you have to do.
First, let’s take a look at Microsoft Inc and estimate its Intrinsic Value.
We need the following inputs easily available from any financial website (Ex: Yahoo Finance)
- Stock Market Price: $33.75 (Oct 23, 2013)
- Current EPS (Earnings Per Share): $2.58
- Estimated Future Growth Rate: 10.8%
- Weighted Average Cost Of Capital (WACC): 7 to 8%
- Average P/E (Price/Earning) Ratio To Use: 15
STEP#1: Figuring out EPS in 10 years.
- Formula: (Annual EPS x Estimated Growth rate^10)
- Microsoft: $2.58 x 10.8%^10 = $7.19
Explanation: If Microsoft continues to grow its EPS at 10.8% over the next 10 years, in 2023 its earnings per share will be equal to $7.19
STEP #2: Figuring out stock value at year 10
- Formula (EPS at year 10 x Average P/E Ratio)
- Microsoft: $7.19 x 15 = $107.85
Explanation: This means that if EPS and Average P/E ratio hold, the price of Microsoft stock will be $107.85 in the year 2023.
STEP #3: Discounting future value to determine today’s Intrinsic Value
- Formula (Future Stock Value/ WACC^10)
- Microsoft $107.85/(1.07^10)=$107.85/1.9671=$54.82
Explanation: That means the stocks Intrinsic Value today should be is $54.82. With the stock price being $33.75 today, it appears that Microsoft is selling at about 38% discount to its Intrinsic Value.
The Weighted Average Cost Of Capital (WACC) used in the calculation above was 7%. In simple terms WACC is the average combined cost of debt and equity. It is not a particularly hard calculation, but it does require some work. I do not believe that you need to do this calculation.
Instead, there are two other ways to think of WACC. You can think of it as ROI % required by you for this investment or as the average stock market return over the last 50 years. To simplify things even further I tend to use 7-8% WACC at this time, unless there are company specific issues that lead me to either increase or decrease the cost of capital.
To be continued…..