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The idea of Intrinsic Value calculation  seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It’s hard enough to predict next year’s profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years?

Let’s look at a sample of a model used to value a company. Because this is a generalized example, don’t worry if some details aren’t clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look:

In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows – each of which are discounted to year zero, the present – in order to determine the present value (PV).

So once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company’s growth rate is assumed to be 5%.

The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model).

Below, we have gone through each component of the model with specific notes:

1. Prior-year cash flow - The theoretical amount, or total profits, that the shareholders could take from the company the previous year.
2. Growth rate - The rate at which owner’s earnings are expected to grow for the next five years.
3. Cash flow - The theoretical amount that shareholders would get if all the company’s earnings, or profits, were distributed to them.
4. Discount factor - The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows’ present value (PV).
5. Discount per year - The cash flow multiplied by the discount factor.
6. Cash flow in year five - The amount the company could distribute to shareholders in year five.
7. Growth rate - The growth rate from year six into perpetuity.
8. Cash flow in year six - The amount available in year six to distribute to shareholders.
9. Capitalization Rate - The discount rate (the denominator) in the formula for a constantly growing perpetuity.
10. Value at the end of year five - The value of the company in five years.
11. Discount factor at the end of year five - The discount factor that converts the value of the firm in year five into the present value.
12. PV of residual value - The present value of the firm in year five.

Once we find out the Intrinsic value of the company, we can calculate the Intrinsic value of a share as well.

Suppose, the company issued 1,000 shares in the market; then the Intrinsic Value of a Share is $ 5.40 ($ 5,397.18/1,000).

And the comparing between the Intrinsic Value of  Share with Market Value of Share helps to make decisions regarding the buying or selling of a particular share.

The following table shows the comparison, decision and reason: (Source: My previous post Stock Buy-Sell Decision Rule)