Company Shares: Intrinsic Value
Buying shares in a company is the same as investing in a business. The objective of owning a business is to make money from business profits.
Example: SupermarketZZ
A supermarket business, SupermarketZZ, is advertised for sale for $10.0m (including stock). The business has been operating for over 10 years, and its financials show consistent profits. Last year, its Net Profit (Earnings) was $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 year's Earnings, the expected Return On Investment (ROI) is:
= Annual Earnings / 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 because they represent the business's Net Profit.
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
= $10,100,000 / 1,000,000
= $10.10 per share
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 (EPS = $1.00).
But what about the current and upcoming year? To decide how much a share is worth, it's important to assess the most likely estimate of Earnings for this year.
Investors are really looking for a good Return On Investment.
What Is an Acceptable Return On Investment?
Investors in businesses need to weigh up the risk against the likely profits.
A typical risk profile for many big investors:
| Minimum ROI | Business / Investment Type | Risk Profile |
|---|---|---|
| 3.0% per year | Government bonds | Almost nil risk of 100% loss |
| 6.0% per year | Large, blue-chip, long-established companies | Very low risk of 100% loss |
| 8.0% per year | Major growth stocks with well-established Earnings performance | Low risk of 100% loss |
| 10.0% per year | Smaller companies with well-established Earnings | Some risk of 100% loss |
| 15.0% per year | Speculative stocks | Risk unknown, but significant risk of 100% loss |
An investor needs to decide what minimum ROI they will accept for a specific investment, based on the assessed risk of 100% loss and the Estimated Earnings.
Investor A
Investor A might decide an ROI of 10.0% is acceptable. This means they are prepared to pay a share price of:
= EPS / ROI = $1.00 / 10.0%
= $10.00
Investor B
Investor B is happy with an ROI of 9.0%, so they are prepared to pay a higher price for the shares:
= $1.00 / 9.0%
= $11.11
Return On Investment, based on Earnings, is the fundamental driver of fair share value.
How to Calculate the Fundamental Intrinsic Value of a Stock
- 1Decide the minimum ROI you want, e.g. 6.0%.
- 2Calculate the Price to Earnings ratio (PE): = 100 / ROI% = 100 / 6.0 = 16.67
- 3Find the latest EPS Estimate for the current quarter and the next quarter, and decide which to use based on your assessment of the economic and business environment. e.g. Current quarter: $0.40 EPS. Next quarter: $0.44 EPS. Work out your adjusted annual EPS (multiply by 4). For example, using just the next quarter as your guide: $0.44 x 4 = $1.76
- 4Calculate the maximum share price based on your minimum ROI and an EPS of $1.76:
Maximum fair value share price = $1.76 x 16.67 = $29.33
This is the Fundamental Intrinsic Value.
Fundamental Intrinsic Value is based on Earnings!
When Does a Stock Sell for Its Fundamental Intrinsic Value?
Not often.
Most of the time, many traders view the company's future prospects with an overly optimistic eye.
If business profits are up and Earnings Estimates for the next four quarters are also up, trader confidence will be bullish. Herd behaviour leads traders to pay more and more for stocks in anticipation of future growth, not wanting to miss out.
Price to Earnings ratios escalate to over 20, or much higher, and can stay there for some time.
When the inevitable next negative news event causes an S&P500 crash, share prices crash down to the level of their Fundamental Intrinsic Value.
Example: A Stock Crash
TrucksRus99 operates an interstate transport business across the US.
Its share price three months ago was $110.00.
Its Earnings Per Share for the previous 12 months were $3.50.
What is the Fundamental Intrinsic Value?
The formula:
Fundamental Intrinsic Value (FIV) = EPS / Required ROI
If an investor wants at least a 6.0% ROI, then for TrucksRus99:
Annual EPS three months ago = $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 the S&P500 has crashed, and TrucksRus99 has crashed with it. Its current share price is $60.00. Will it fall further, or has it hit rock bottom?
The company has just released Earnings Estimates for the next 12 months of $3.30 per share.
Recalculating the FIV, staying 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 stocks usually revert to their FIV after a crash.
How to Cut Your Losses Dramatically
Why UIS Risk Ratings Cut Your Losses and Drawdowns
Applying the UIS Risk Ratings in advance of an S&P500 crash allows you to exit at the close on an up day, rather than in a rushed stop-loss situation once the fall has already started.
How to Cut Losses and Drawdowns
Sample UIS Risk Rating Report