Intrinsic Value Formula: Your Thoughts!

[tybutler]

G'day all:

I've been investing for a few years but haven't had a clear-cut strategy for choosing investments. Note that I'm not particularly interested in trading, but in finding undervalued companies with good fundamentals for growth in the long term.

Recently I've stumbled on this formula which is used to find the intrinsic value of a stock (i.e. what the stock is 'really' worth as opposed to what its share price is). It basically says that Return on Equity is the most important function when valuing stocks.

Anyway, broken down the formula is basically:

ROE/IRR*EQPS

Where:
ROE = Return on Equity
IRR = Internal Rate of Return (I've been using 15%)
EQPS = Shareholders Equity Per Share

What I'm interested in knowing is the opinions of ASF members on this formula, realizing that other fundamentals also need to be included when evaluating a company.

Any thoughts would be appreciated as I'm in the beginning stages of forming a stock selection strategy.

Thanks in advance,

Ty.

[ducati916]

ty

What I'm interested in knowing is the opinions of ASF members on this formula, realizing that other fundamentals also need to be included when evaluating a company.

And therein lies the crux.
Without knowing what other fundamentals you are subjecting to scrutiny, there can be no sensible opinion offered. For one company, with XYZ fundamentals, it may reveal a rational valuation, but for company ABC, the resulting valuation may be irrational.

jog on
d998

[tybutler]

ty



And therein lies the crux.
Without knowing what other fundamentals you are subjecting to scrutiny, there can be no sensible opinion offered. For one company, with XYZ fundamentals, it may reveal a rational valuation, but for company ABC, the resulting valuation may be irrational.

jog on
d998

What I'm asking about is specifically this formula. Does it make sense? Can you see anything wrong with it? As I said, I know that other factors need to be considered when valuing a company, but it's this one factor that I was enquiring about. Has/does anyone use it as well (in combination with other factors of course)?

Ty.

[Realist]

It looks okay to me...

Too complicated though, and it does not take into account the companies current financial status.

There is no point in making $100K a year if you owe $20M in debt. The company maybe worthless.

Yet a company that made no profit and has $20M in assets is worth at least $20M.

[tybutler]

It looks okay to me...

Too complicated though, and it does not take into account the companies current financial status.

There is no point in making $100K a year if you owe $20M in debt. The company maybe worthless.

Yet a company that made no profit and has $20M in assets is worth at least $20M.

Agree. Debt is the first thing I look at after using this formula.

Also agree that it is too complicated so I use a 'dumbed down' version which seems to get a similar answer to the original formula.

Will have to trial it for a while (probably a year) to see if there is any worth in finding intrinsic values. What I DO know, is that according to this, there are a tonne of companies excessively overvalued. If that's important or not time will tell.

[stoxclimber]

IMO there are no shortcuts to valuation...except comparables and even that requires way more consideration than working out ROE/IRR etc.

You can't divorce the valuation of a companies fundamentals from that which actually determines the cash flows of the company and the growth potentials, hence, any simple formula will be necessarily lacking.

[Smurf1976]

IMO there are no shortcuts to valuation...except comparables and even that requires way more consideration than working out ROE/IRR etc.

You can't divorce the valuation of a companies fundamentals from that which actually determines the cash flows of the company and the growth potentials, hence, any simple formula will be necessarily lacking.

Agreed with your comments but in practice surely there must be a "rule of thumb" formula that is a reasonable starting point?

I mean, everything from the behaviour of road traffic through to water inflows to a dam can be modelled mathematically without need to forecast the actual weather etc so it must be possible to do something reasonable with stock valuations based only on financial data?

[Zenith]

G'day all:

I've been investing for a few years but haven't had a clear-cut strategy for choosing investments. Note that I'm not particularly interested in trading, but in finding undervalued companies with good fundamentals for growth in the long term.

Recently I've stumbled on this formula which is used to find the intrinsic value of a stock (i.e. what the stock is 'really' worth as opposed to what its share price is). It basically says that Return on Equity is the most important function when valuing stocks.

Anyway, broken down the formula is basically:

ROE/IRR*EQPS

Where:
ROE = Return on Equity
IRR = Internal Rate of Return (I've been using 15%)
EQPS = Shareholders Equity Per Share

What I'm interested in knowing is the opinions of ASF members on this formula, realizing that other fundamentals also need to be included when evaluating a company.

Any thoughts would be appreciated as I'm in the beginning stages of forming a stock selection strategy.

Thanks in advance,

Ty.

I taught Financial Analysis but I don't understand your formula. What are the other unknowns?

[jhardwick]

Hi tybutler,

I use the same formula that Roger Montgomery used to create his valuation tables 11.1 and 11.2 in his book Value.Able. It is:
IV = P% x Income/RR + (1-P%) x (Income/RR x ROE/RR) where P% is the payout ratio
The first part of this formula values the perpetuity income stream; the second part values company growth due to retained earnings.

I have derived this formula on the forums of the Student2Trader website if you are interested. Search "Student2Trader" -> go to "Forums" -> "Trading and Investing -> "Roger Montgomery Complete Intrinsic Value Formula Using ROE Explained". I can't post links sorry.

Justin

[burglar]

Agreed with your comments but in practice surely there must be a "rule of thumb" formula that is a reasonable starting point? ...

Hi Smurf,

Have you found a reasonable starting point yet?

[ParleVouFrancois]

What you've found tybutler is what I'm learning in my 2nd year corporate finance degree, it is the theoretical valuation of a share but in a very simplified form, but it is based on many assumptions being true, even though in reality it is rarely the case.

As others have pointed out, it doesn't take into account company level risk factors such as debt to equity ratios etc (which can have a massive effect on the IV), as well being only backwards looking with no apparent ability to shift for changes in growth rate.

IMO to get a 'basic' valuation down pat, use figures like Net Present Value, Internal Rate of Return, to value the company without any risk of bankruptcy, read the debt to equity ratios as well as cashflow statement and how it looks compared to the profit & loss statement, and reduce that initial valuation to some percent of the original value.

Finding the 'intrinsic value' of a company is a complicated process, which I guess explains why there are so many books/courses on how to do it! Just always remember to have a large margin of safety

[burglar]

... Finding the 'intrinsic value' of a company is a complicated process, which I guess explains why there are so many books/courses on how to do it! Just always remember to have a large margin of safety

Hi ParleVouFrancois,

If a hypothetical company had zero debt and a ROE of 31%,

And it had been pumped and dumped by Motleys fool.

How would I know if the current SP is above or below IV?

[McLovin]

Hi ParleVouFrancois,

If a hypothetical company had zero debt and a ROE of 31%,

And it had been pumped and dumped by Motleys fool.

How would I know if the current SP is above or below IV?

You're really asking a "how long is a piece of string" question. Ask 100 people you'll get a 100 different answers.

MF are pumping and dumping? I don't take their analysis too seriously, but I don't think they're in the league of P&D.

[burglar]

You're really asking a "how long is a piece of string" question. Ask 100 people you'll get a 100 different answers.

MF are pumping and dumping? I don't take their analysis too seriously, but I don't think they're in the league of P&D.

I'm asking a forum full of investors and so far I haven't had a single answer.
If I had a 100 different answers I could find an average, a median, a mode and the range!

All I have so far is a formula that seems incomplete and that I do not understand.

Or pin a tail on the donkey.

[McLovin]

I'm asking a forum full of investors and so far I haven't had a single answer.
If I had a 100 different answers I could find an average, a median, a mode and the range!

All I have so far is a formula that seems incomplete and that I do not understand.

Or pin a tail on the donkey.

If the answer was easily arrived at, the purpose of markets would cease to exist.

[burglar]

If the answer was easily arrived at, the purpose of markets would cease to exist.

I love the auction!
However, I don't want to pay too much and be on the wrong side of the trade from the fall of the hammer!!

I have found what I was looking for:
http://www.investopedia.com/articles...#axzz2AQsVsJP1

[McLovin]

I love the auction!
However, I don't want to pay too much and be on the wrong side of the trade from the fall of the hammer!!

I have found what I was looking for:
http://www.investopedia.com/articles...#axzz2AQsVsJP1

It's the sort of neat formula economists love.

[burglar]

It's the sort of neat formula economists love.

It is complete and simple.

[setandforget]

The investopedia formula looks simple but still requires you or the company to guess some numbers like future dividends or share price or growth rate. But if you knew these things in advance you wouldn't need the formula.

[burglar]

MF are pumping and dumping? I don't take their analysis too seriously, but I don't think they're in the league of P&D.

I really don't know all that much about P&D ... I generally avoid!

This company was not empty when MF reported.
Looking at the Volume and share price action,
I'd hazard a guess that it is now well pumped,
and in process of being dumped!!

Just a burglar's humble opinion!

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