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Valuation of a Stock

As you can read on my blog I’m using The PollieCode to screen and evaluate possible buyable stocks. As a result I’m placing a stock on my watch list or forget about it (for a while). And yes when a stock is on my watch list, there is a possibility that I will buy this stock 😉

Since I’m using my blog to share my thoughts, buying decision and portfolio update with you readers, I have noticed that The PollieCode is evolving. The original 10 Codes are still there, but some new metrics have been added.

This is, in my opinion, one of the great advantages of a blog. When writing a post, I have the feeling that I have to take accountability, to you as my readers, for all my actions and decisions. And yes, I know there is only one person responsible for my action (and that’s me!), and I do not need to justify my actions to anyone but me. But this feeling takes my decisions to a higher level. And therefore I’m grateful to you, my readers. I think it makes me a (little bit) better investor. So Thank You!

If you take a look at The PollieCode and my latest analysis, you can see that I’ve added a model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. As a wise man once sad: Price is what you pay, value is what you get. (B. Graham). With this in mind I think I do not need to explain why it is useful to determine the intrinsic value.

However there are a number of different methods/models to determine the intrinsic value. But which one to use?

Gordon and Shapiro
One of these methods is the Constant growth model (a.k.a. Gordon Growth Model or the Gordon and Shapiro model (1953)). This model determines the intrinsic value: Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends.

Stock Value (P) = D / (k-G)

Where:

D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)

On the Internet there is also a model, which is a slight adaptation of the Gorden Growth model

Stock Value (P) = (D*(1+G))/ (k-G)

Dividend Discount Model
This model is for determine the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued

Intrinsic value = Div / (1+r)n

Where:
Div = Dividends expected in one period
r = Required rate of return
n = number of years

Benjamin Graham revised model
In The Intelligent Investor, Ben Graham describes his formula for the intrinsic value. In 1974 he revised his formula (his knowledge and experience also evolved) in order to more accurately account for changes in interest rates. The 1974 – formula is as follows:

V = (EPS x (8.5 + 2 g) x 4.4) / Y

Where:
V = Intrinsic Value
EPS = the company’s last 12-month earnings per share
8.5 = the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham
g = the company’s long-term (five years) earnings growth estimate
4.4 = the average yield of high-grade corporate bonds in 1962, when this model was introduced
Y = the current yield on AAA corporate bonds

In conclusion
All models calculate different intrinsic values. I once read that this is because all models are subject to the risk and volatility that exists in the market. Personally I think that every economist, financial whiz kid or academic came up with its own model, which is accurate for his or her use. Not one model is THE model.

So therefore a model cannot be used to pin point the exact intrinsic value. But it gives me a direction to look for. And I’m using it to give me an indication of a company’s financial health and to determine the margin of safety.

In my latest analysis I’ve used the Gordon and Shapiro model. This because I felt at that point that this model gave the most realistic intrinsic value.

Which model(s) are you using, and why?
I like to hear from you and thanks for stopping by!

Cheers,

Pollie

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