Monday, May 23, 2011

Stock Fair Value estimate via Discounted Cash Model

So the Fair Value Graph at Morningstar, applying a Discounted Cash Model, caught my attention. It makes economic sense, has a positive correlation to the underlying indices, naturally I looked for details. The guy at "My Coverd Call Blog" made a pretty cool post explaining the formula:

Benjamin Graham describes a simpler formula to determine intrinsic value.
Formula: V = EPS x (8.5 + 2G) * (4.4 / Y)
  • 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 future 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
I use the modified formula from Old School Value, which uses a P/E of 7 for a no-growth company and a multiplier of 1.5G rather than 2G, since these are more conservative.

Modified Formula: V = EPS x (7 + 1.5G) * (4.4 / Y)
The original formula uses the last 12-month EPS (TTM), however, like Old School Value, I normalize EPS over a 10 year period, which estimates future EPS for the next 5 years, using a linear forecast based on the previous 10 years, and then takes the median of the previous 5 years and next 5 years to arrive at a normalized EPS. For estimated future 5yr growth rate I use 3 different sources, 1) Yahoo Finance, 2) Morningstar, and 3) MSN Money. I found that each site has a different 5yr estimate, so I use an average of these estimates."

We can see that the it's mostly straight forward, just that earnings expectations remain uncertain. So that is where more research remains to be done!

0 Reflections: