Discuss the concept of intrinsic value and how it is determined. Include a real-world example
Intrinsic value refers to the value of an asset or a firm based on the underlying perception of the true value of the business aspects which include both tangible and intangible factors. The intrinsic value may or may not be equal to the market value.
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Intrinsic value can be measured using the formula:
Where: Div is expected dividend
r = required rate of return
In the real world of business, intrinsic value is used by investors to determine the value of some investment before making any investment decisions.
The Hall Dental Supply Company sells at $32 per share, and Randy Hall, the CEO of this well-known Research Triangle firm, estimates the latest 12-month earnings are $4 per share with a dividend payout of 50%. Hall’s earnings estimates are very accurate.
What is Hall’s current P/E ratio?
Current PE ratio = Price per Share / Earning per share
= $32/$4 = 8
If an investor expects earnings to grow by 10% a year, what is the projected price for next year if the P/E ratio remains unchanged?
Earning in Year 0 = $4
Growth rate = 10%
Earning in Year 1 = E0 x (1+g)
=$4 x (1+10%) = $4.4
Since P/E is unchanged = 8
Price per share = PE ratio x Earning per share
=8 x $4.4 = $35.20
Ray Parker, President of Hall Dental Supply Company, analyzes the data and estimates that the payout ratio will remain the same. Assume the expected growth rate of dividends is 10% and an investor has a required rate of return of 16%. Explain whether or not this stock would be a good buy and support your rationale.
Dividend payout ratio (D/E) = 50%
Dividend growth rate = 10%
Investor’s required rate of return = 16%
Dividend paid = 50% x $4.4 = $4.4
Expected rate of return = D1/PO + g
= $2.2/$32 + 10% = 6.88% + 10%
= 16.88%
The expected return of this stock is higher than required rate of return, hence it is a good stock to buy. Therefore, it is a buy stock.
If interest rates are expected to decline, discuss the likely effect on Hall’s P/E ratio.
If the interest rate increases, the profit of the company will decline which will results in decline in earnings per share, hence increase in the P/E ratio of Hall Dental Supply Company. This is because when the interest rate increases, the interest expense will increase which will result in decline in the overall profit made by the company. Decrease in profit also has an impact of reducing earning per share, hence an increase in the P/E ratio.
Discuss the impact of the market on well-diversified portfolios. What does this suggest about the performance of mutual funds? Include real-world examples in your explanation.
Portfolio is the combination of several investments, which reduces the risk through diversification. Only systematic risk can be diversified in the market. Well diversified portfolio in the market has the impact of reducing diversifiable risk and guarantees investors that if a given security is not doing well, the other may be doing well, hence the risk of high loses is greatly minimized (Goetzmann & Alok, 2008). For instance, in the real world scenario, an investor can focus on the oil industry and agricultural industry. During the unfavorable climatic condition, the agricultural sector may not be doing well and the return from that sector will be low resulting in loses. However, since the investor has invested in the oil industry as well, the losses made from agricultural sector will be compensated by returns made from oil industry.
Discuss the relationship between fundamental analysis and intrinsic value. Include real-world examples in your explanation
Intrinsic value refers to the value of a company or stock determined through fundamental analysis without reference to its market value. It is generally calculating the discounted future income generated by the asset to obtain the present value. Some analyst also look at the current liquidated value to calculate the intrinsic value. Fundamental analysis is the technique used in calculating the intrinsic value of stock by checking the financial, economic and other related factors of stock. In the real world, fundamental analysis is used in evaluating stock of various firms by investors and investment analyst in order to find out the stock it is worth investing in.
References
Goetzmann, W. N., & Kumar, A. (2008). Equity portfolio diversification. Review of Finance , 12 (3), 433-463.
