What is the intrinsic value of a share? How is it determined?
Fundamental analysis propounds that the intrinsic value is, and has to be, based on the benefits that accrue to investors in the share. As they return to shareholders is in the form of dividends, under strict fundamental analysis, the present value of future dividends discounted based on its perceived safety or risk is its intrinsic value. The intrinsic value is based on the dividend because that is what a shareholder or investor receives from a company, and not on the earnings per share of the company. This distinction is very important.
Calculation of Intrinsic value
How, then, does one calculate the intrinsic value of a share? Let us assume that one expects a return of 20% on an investment every year for 3 years. Let us also assume that the company would pay dividends of 20%,25% and 30% on its Rs.10 shares. The dividend received on a share would, therefore, be Rs. 2.00 in the first year, Rs. 2.50 in the second, and. Rs 3.00 in the third. Let us also assume that the share can be sold at Rs 200 at the end of 3 years.
The intrinsic value of the share will be:
The logic is to discount the dividend received and anticipated to be received in future years and the expected price at a future date with the return or yield expected. Since the price at that future date is also considered, the possibility of capital appreciation is considered and this is why this method of arriving at the intrinsic value is considered the most balanced and fair. If the market price of the share is below Rs.120.88 then the share is below its intrinsic value and therefore well worth purchasing. If, on the other hand, the market price is higher, it is a sell signal and the share should be sold.
Fundamental analysis propounds that the intrinsic value is, and has to be, based on the benefits that accrue to investors in the share. As they return to shareholders is in the form of dividends, under strict fundamental analysis, the present value of future dividends discounted based on its perceived safety or risk is its intrinsic value. The intrinsic value is based on the dividend because that is what a shareholder or investor receives from a company, and not on the earnings per share of the company. This distinction is very important.
Calculation of Intrinsic value
How, then, does one calculate the intrinsic value of a share? Let us assume that one expects a return of 20% on an investment every year for 3 years. Let us also assume that the company would pay dividends of 20%,25% and 30% on its Rs.10 shares. The dividend received on a share would, therefore, be Rs. 2.00 in the first year, Rs. 2.50 in the second, and. Rs 3.00 in the third. Let us also assume that the share can be sold at Rs 200 at the end of 3 years.
The intrinsic value of the share will be:
The logic is to discount the dividend received and anticipated to be received in future years and the expected price at a future date with the return or yield expected. Since the price at that future date is also considered, the possibility of capital appreciation is considered and this is why this method of arriving at the intrinsic value is considered the most balanced and fair. If the market price of the share is below Rs.120.88 then the share is below its intrinsic value and therefore well worth purchasing. If, on the other hand, the market price is higher, it is a sell signal and the share should be sold.
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