Intrinsic Value versus Market Price

Scenario Assumptions:

• Stock G has the following:
  • Expected dividend per share (E(D1) = 4 pesos.
  • Current price of the stock (P0) = 48 pesos.
  • Expected price at the end of 1 year (E(P1​)) = 52 pesos.

Formula for Expected Holding-Period Return (HPR):

HPR= E(D1)+[E(P1)−P0]P0HPR=P0​E(D1​)+[E(P1​)−P0​]​

Where:

• E(D1) is the expected dividend per share.
• E(P1) is the expected stock price after 1 year.
• P0 is the current stock price.

Substitute values into the formula:

HPR=4+(52−48)48=4+48=16.7%

HPR=48+(52−48)​=48+4​=16.7

Explanation:
This means that the investor expects to earn a 16.7% return from the stock over 1 year, which includes:

• Dividend Yield: The dividend (E(D1)) relative to the current price (P0​)
• = 4 divide 48 =8.3%

• Capital Gains Yield: The increase in the stock price (E(P1)−P0E(P1​)−P0​) relative to the current price (P0)
• = E(P1)−P0 divide P0
• = 52−48 divide 48 = 8.3%P0​

Thus, the total expected return (HPR) is 16.7%.

Capital Asset Pricing Model (CAPM)

CAPM is used to calculate the required return for a stock, considering its risk in comparison to the market.

CAPM Formula:

k=rf+β⋅[E(rm)−rf]k=rf​+β⋅[E(rm​)−rf​]

Where:

• kk = Required rate of return (the return an investor expects to earn).
• rf​ = Risk-free rate (the return from a risk-free investment, like government bonds).
• E(rm​) = Expected market return (the average return from investing in the market).
• β = Beta, which measures the stock's risk relative to the market:
  • If β>1, the stock is riskier than the market.
  • If β<1, the stock is less risky than the market.

Example Values:

• rf=6%rf​=6% (Risk-free rate).
• E(rm)−rf=5% (Market risk premium, the extra return the market offers over the risk-free rate).
• β=1.2 (This stock is 20% riskier than the market).

Substitute values into the CAPM formula:

k=6% + 1.2 x 5% = 6% + 6% = 12%

Explanation:

• The required rate of return (kk) for this stock, considering its risk, is 12%.
• This means the investor expects to earn at least 12% from this stock, given its level of risk.

Comparing Expected Return vs. Required Return

Now, let's compare the expected return with the required return:

• From the previous calculation, the expected return (HPR) is 16.7%.
• From the CAPM formula, the required return is 12%.

Difference:

E(r)−k=16.7%−12%=4.7%E(r)−k=16.7%−12%=4.7%

Interpretation:

• Since the expected return (16.7%) is higher than the required return (12%), this stock provides a better return than what the investor would require, considering its risk.
• This makes the stock a good investment because it offers a return higher than expected from its level of risk.

Intrinsic Value of a Stock

The intrinsic value (V0V0​) of a stock is an estimate of its true worth, based on the present value of future cash flows (dividends and expected price), discounted at the required rate of return.

Intrinsic Value Formula:

V0=E(D1)+E(P1)1+kV0​=1+kE(D1​)+E(P1​)​

Where:

• E(D1)E(D1​) is the expected dividend.
• E(P1)E(P1​) is the expected price after 1 year.
• kk is the required return (calculated by CAPM).

Example Values:

• E(D1)=4E(D1​)=4 pesos.
• E(P1)=52E(P1​)=52 pesos.
• k=12%k=12% (Required return from CAPM).

Substitute values into the intrinsic value formula:

V0=4+521.12=561.12=50V0​=1.124+52​=1.1256​=50

Interpretation:
The intrinsic value of the stock is 50 pesos, meaning this is what the stock is truly worth based on the expected dividends and price.

Comparing Intrinsic Value vs. Market Price

Now, compare the intrinsic value (V0​) to the market price (P0​):

• Intrinsic value (V0​) = 50 pesos.
• Market price (P0) = 48 pesos.

Conclusion:

• Since V0>P0​ (50 pesos > 48 pesos), the stock is undervalued.
• This means the stock is priced below its true worth, so it might be a good investment opportunity.