How much are a company’s shares really worth
1.0 Company shares Intrinsic Value
Buying shares in a company is the same as investing in a business. The objective with owning a business is to make money from business profits.
Example
A supermarket business SupermarketZZ is advertised for sale for $10.0m (including stock). The business has been operating for over 10 years and financials show consistent profits. In the last year the Net Profit (Earnings) were $1.0m
If the business was purchased for $10.0m and an extra $100k was allowed for operating cash flow, the total investment would be $10,100,000.
Based on last years Earnings, the expected Return On Investment is:
-Earnings (annual) divided by Total investment
=$1,000,000 / $10,100,000
=9.9%
This is the bottom line for investing in a business – the ROI.
Earnings are critical to ROI as they represent the business Net Profit.
1.1 What is the Fundamental Intrinsic Value
A group of people decide to buy SupermarketZZ by setting up a new Company to own it.
They create 1,000,000 shares. The nominal value of each share is
=Total investment / Number of shares
= 10,1000,000 / 1,000,000 =$10.10 per share
1.2 How much is a share worth
This is where Earnings Estimates come in.
SupermarketZZ reported Earnings last year of $1.0m which equates to $1.00 per share. ie. EPS – $1.00.
But what about the current and upcoming year. It is important to assess the most likely estimate of Earnings for this year to decide how much a share is worth.
Investors are really looking for a good Return On Investment (ROI)
1.3 What is an acceptable Return On Investment (ROI)
Investors in businesses need to weigh up the risk compared to the likely profits.
A typical risk profile for many big investors:
Minimum ROI Business/investment type Risk profile
3.0% per yr Government Bonds Almost nil risk of 100% loss
6.0% Large, blue chip, long Very low risk of 100% loss
established companies
8.0% Major growth stocks Low risk of 100% loss
well established Earnings
performance
10.0% Smaller companies but Some risk of 100% loss
well established Earnings
15% Speculative stocks Risk unknown but risk of 100% loss
is significant
An investor needs to decide what minimum ROI they will accept for a specific investment with regard to the assessed risk of 100% loss and the Estimated Earnings.
For the SupermarketZZ example, investor A might decide that a ROI of 10.0% is acceptable to them. This means they are prepared to pay a share price of:
=Earnings Per Share / ROI
=$1.00 / 10.0%
=$10.00
Investor B is happy with a ROI of 9.0%. This means investor B is prepared to pay a higher price for the company shares of:
-$1.00 / 9.0%
=$11.11
Return on Investment is the fundamental driver of fair share value which is based on Earnings.
1.4 To calculate the Fundamental Intrinsic Value of a stock
1. Decide the minimum ROI% desired. e.g. 6.0%
2. Calculate the Price to Earnings ratio (PE)
=100 / ROI%
=100 / 6.0
=16.66
3. Identify the latest EPS Estimate for the current Quarter and the Next Quarter. Decide which to use based on your assessment of the economic/business environment.
e.g.
Current Quarter $0.40 EPS
Next Quarter $0.44 EPS
Decide your adjusted annual EPS (multiply by 4).
Perhaps use just the Next Quarter as your guide and multiply 0.44 X 4 = $1.76
4. Calculate the maximum share price based on the desired minimum ROI and using an EPS of $1.76
-Max Fair Value share price = $1.76 X 16.66 = $29.32
This is the Fundamental Intrinsic Value.
Fundamental Intrinsic Value is based on Earnings !
1.5 When does a stock sell for it’s Fundamental Intrinsic Value price.
Not often. Most of the time many traders look at the future prospects of the company with an overly optimistic view.
If business profits are Up and Earnings Estimates for the next 4 Quarters are also Up, trader confidence will be bullish. Herd behaviour leads to traders paying more and more for stocks in anticipation of future growth and not wanting to ‘miss out’.
Price to Earnings ratios escalate to over 20 or much higher and can stay at that level for some time.
When the inevitable next negative news event occurs that causes a S&P500 crash, share prices crash down to the level of Fundamental Intrinsic Value.
Example stock crash
Company TrucksRus99 operates an interstate transport business across the US.
It’s share price 3 months ago was $110.00.
Earnings per Share for the previous 12 months were $3.50
What is the Fundamental Intrinsic Value
The formula:
-Fundamental Intrinsic Value = EPS / Required ROI
If an investor wants at least a 6.0% ROI then for TrucksRus99:
-3mths ago annual EPS was $3.50
FIV = $3.50 / 6.0% = $58.33
The stock was trading at $110 indicating bullish exuberance with almost half the share price being purely speculative.
Now that the S&P500 has crashed, TrucksRus99 has also crashed. It’s current share price is now $60.00. Will it fall further or has it hit rock bottom.
The company has just released Earnings estimates for the next 12 mths of $3.30 per share.
Now to recalculate the FIV:
-We will stay with our desired ROI of 6.0%
-FIV = $3.30 / 6.0% = $55.00
The stock is currently trading at $60.00. It could be expected to fall further as usually stocks revert to FIV after a crash.
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