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