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Tag: stock-market

  • Intrinsic Value

    Maximizing the intrinsic value is the main financial goal of managers at publicly owned companies.

    The intrinsic value and the actual market stock price are determined by several factors, although their underlying foundations are the same.

    Determinants of Intrinsic Value

    The value of any asset, including a share of stock, is fundamentally based on the stream of cash flows that the asset is expected to produce for its owners over time.

    The key determinants of a stock’s intrinsic value are the “true” expected cash flows and the “true” risk associated with those cash flows.

    1. Managerial Actions and Environment: Managerial actions, combined with the economic environment, taxes, and the political climate, influence the level and riskiness of the company’s future cash flows.
    2. Expected Cash Flows: Investors prefer higher expected cash flows.
    3. Perceived Risk: Investors dislike risk, so the lower the perceived risk, the higher the stock’s price.
    4. Long-Run Concept: Intrinsic value is a long-run concept; management’s goal is to maximize the firm’s intrinsic value, which maximizes the average price over the long run.
    5. Estimation: Intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data, as calculated by a competent analyst.

    Determinants of Market Stock Price

    The market price is the actual price at which the stock sells, based on perceived, possibly incorrect, information available to the marginal investor.

    • Perceived Cash Flows and Risk: The market price is based on “perceived” investor cash flows and “perceived” risk, given the limited information investors have.
    • Marginal Investor: It is the views of the marginal investor (the investor currently trading the stock) that determine the actual stock price.
    • Equilibrium: When a stock’s actual market price equals its intrinsic value, the stock is in equilibrium, and there is no pressure for a price change. Market prices can, and do, differ from intrinsic values, but they tend to converge over time as the future unfolds.

    Valuation Models

    Financial analysts use models to estimate a stock’s intrinsic value, including:

    1. Discounted Dividend Model (DDM): Focuses on the present value of expected future dividends.
    2. Corporate Valuation Model: Focuses on the firm’s future free cash flows (FCF), which are discounted using the Weighted Average Cost of Capital (WACC).