Intrinsic Value of Shares

Value Investing is a type of investing in which the trader buys shares in cheap price and sell them in higher price. Sure this is common feature of all tradings. But following differentiate it from other tradings:

• It is based on fundamental of company rather than technical analysis
• It is long term investing (more than 3 years)

According to this trading paradigm, intrinsic value of a share is calculated based on fundamentals such as EPS, P/E, Dividend, Dividend Payout Ratio, EPS-Growth 10 year.

Since it is a long term investment, someone can wonder if a share's price is fair at a given time. In this text, i will explain a very simple technique to calculate intrinsic value of a share which is described in Getting Started in Value Investing by Charles Mizrahi. Please note that, this technique is more accurate on shares of which return on equity (ROE) in last 10 years is more than 15 and each year earning is increased around 10%. I will use HMV Group (LSE.HMV) share to explain the steps. Financial of HMV at point of writing this article is as follows:

• Price (P):112.70p
• EPS:11.10p
• PE:10.15
• Dividend:5.6p
• Divident Payout Ratio (DPR):66.67%
• EPS-Growth:20.65 %

1-) Estimate EPS Growth (EPS_G) for the end of next five years.

• If average EPS Growth is greater than 15% over the past 10 years, then we take EPS_G as 15%.
  
• Otherwise use 10% as EPS_G

For HMV, even though EPS_G is around 20.65, i would like to take EPS_G as 10% for bad case scenario.

2-) Estimate P/E (PE_G) for the end of next five years

• If average PE is above 20 over the past 10 years, then we take PE_G as 17
• Otherwise use 12 as PE_G

For HMV, I would like to take PE_G as 10 for a more accurate estimate.

3-) Calculate EPS by the end of 5 (N) years
For this, we use simple interest rate equation :

EPS_N= EPS*((1+EPS_G)^N)= 11.10*((1+0.10)^5)=17.88

So by the end of 5 years, we expect EPS will be 17.88 p

4-) Calculate Price by the end of 5 (N) years:
Since Price= PE*EPS, therefore:

P_N=PE_G*EPS_N=10*17.88=178.8p;

which is the price of HMV share by the end of 5 years

5-)Calculate dividends for next five years
We project next five (N) years dividends by using past five years. We sum all dividends and then multiply it with Dividend Payout Ratio (DPR).

D_N= DPR*(d_n+d_n-1+d_n-2+d_n-3+.... d_N-1)

where d_n is the past year's dividend.
So dividend of HMV will be: D_5=0.6657*(5.6+7.4+7.4+7.4+6.9)=23.1

6-) Calculate Total Share
Total share price is:

T_N=P_N+D_N=178.8+23.1= 201.9p

7-) Calculate Present value
Based on a return rate (r) we calculate present value of T_N or in other words intrinsic value of share (IV):

IV_N=TN*((1+r)^-N)

Let say, we would like to have 15 % return on our investment, then intrinsic value of HMV is:

IV=201.9*((1+0.15)^-5)= 100.3800.

At the moment price of HMV is 112.70p. Therefore, we can conclude that HMV is expensive according to its fundamental and return rate. We should wait HMV price goes more down in order to make profitable long term investment.

Please note this is a simple technique to judge if a share has a fair price at a time. There are other fundamental factors have to be analysed before using technique.