The intrinsic value approach or the fundamental analysis of stocks prices is equal to the dividend over the interest rate. This approach is based on predictions of future cash flows and profitability. Present Discount Value is one of the popular methods used in pricing stocks.
The main use pricing stocks are to predict future market prices, and profit from stocks that are undervalued and overvalued.
Discounted Cash Flow
This method involves discounting the profits (dividends, earnings and cash flows) that the stock will provide and calculates the value of the stock at a future sale. This discounted rate includes a risk premium.
Present Discount Value (PDV) = D/i
To price a stock, PDV = D(1+g)/(i-g)
Which is the dividends increased every time by g (g = growth rate of dividends)
i = interest rate on a safe bond + an assumed risk premium
Risk premium = equity premium
Weaknesses in PDV Approach to Pricing Stocks
- Nobody knows for sure what a company’s future earnings and future dividends will be.
- Stocks and bonds do not carry equal risk. Bonds are considered to be safer investments.
- Even if you know that the stock is overpriced, if the Present Discount Value is less than the price, you can still make a profit.
There is a strong inverse relationship between stock prices and interest rates. If interest rates fall, bonds pay a lower return, so there is incentive for people to buy stocks instead of bonds.
Other Approaches to Pricing Stocks
- Technical Analysis – this method looks for patterns in the past.
- The Behavioral Approach to Investing – focusing on investor psychology. For example, Warren Buffet famously is a value investor and looks at stocks in the long term.