How To Determine The Intrinsic Value Of Any Company (Part 2)

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.

Coins and plant, isolated on white background

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)

  1. Stock Market Price: $33.75 (Oct 23, 2013)
  2. Current EPS (Earnings Per Share): $2.58
  3. Estimated Future Growth Rate:  10.8%
  4. Weighted Average Cost Of Capital (WACC): 7 to 8%
  5. 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…..