• / Free eNewsletters & Magazine
  • / My Account
Home>Research & Insights>Investment Insights>A Better Way to Intrinsic Value

Related Content

  1. Videos
  2. Articles
  1. Sizing Up the 3 Biggest Nontraditional Bond Funds

    The big names in this category have more to prove before we can fully recommend them, says Morningstar's Eric Jacobson.

  2. A Gameplan for Playing High Yield

    Although the default picture has improved in high yield , junk bonds could still get clocked if the economy falters or we face a double-dip recession, says Morningstar's Eric Jacobson.

  3. Ferri: 3-Fund Portfolio the Simplest Way to Best Return

    U.S.-stock, foreign-stock, and bond index funds can constitute a core portfolio with the flexibility to expand into other asset classes if desired, says author and advisor Rick Ferri.

  4. Be Prudent in the Hunt for Yield

    Investors should appreciate the risk trade-off, the effects of inflation, and the value that a fund manager can add in certain higher-yielding assets, says Morningstar's Shannon Zimmerman.

A Better Way to Intrinsic Value

Focus on expected returns from conservatively forecast cash flows and not on the false precision of academic models, writes Morningstar’s Sam Lee.

Samuel Lee, 05/27/2014

A version of this article was published in the May 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

In the first part of this two-part series, "Understanding Intrinsic Value," I briefly described intrinsic value and its relationship with time and risk. In this second and final part, I describe a more practical way to apply the intrinsic-value framework.

Intrinsic value may be the central idea of investing, but it has a big problem: It collapses two key estimates--future cash flows and the discount rate--into a single value. Even minor changes in future cash flows or discount rates can result in huge swings in intrinsic value.

Consider the Gordon dividend growth equation, which provides the present value of a cash flow that grows at a constant rate in perpetuity:

P = D/(r - g),

where P is present value, D is the cash flow one year from the present, r is the required rate of return (or the discount rate), and g is the annualized growth in the cash flow.

The table below shows the present values of cash flow streams where D is $100, g is 1%, and r ranges from 3% to 10%. Even though I'm only changing r, raising g by 1 percentage point has the same effect as lowering r by 1 percentage point. Note that as the discount rate falls, present value becomes increasingly sensitive to changes in the discount rate.

Samuel Lee is an ETF Analyst with Morningstar.

©2017 Morningstar Advisor. All right reserved.