Question

in 400 words describe the following,

1. Offer some reasons that the intrinsic value that you might calculate with the methodologies learned might yield a price different than what the stock trades at in the stock market. You can reference any method of valuation models in offering thoughts on why there might be differences between intrinsic and market values.

2. Describe three different examples of analysis where you might use discounted cash flows.

Answer 1

1.Reasons for difference between intrinsic value and the market value are given below :

• Shareholders are future oriented - shareholders are less interested in the present condition of the company than the future of the company, because they expect company to grow both financially and operationally in the future. They expect that the performance of the company increases, because of which the future worth of the company increases. Therefore, intrinsic value (which is the current worth of the business) differs from the market value (which is the future worth of the business from shareholders point of view).
• Intrinsic value is derived from balance sheet figures- instresic value is determined based on the recent balance sheet of the company. As balance sheet is internally generated it is not always completely accurate representation of assets and liabilities. Further, if the company has borrowed money, the debt is shown in balance sheet reduce the intrinsic value or networth of the company, but in reality if the cost of debt is less than ROI (returns on investment) then the financial position of the company is good and market value of shares increases. This is not reflected in balance sheet, as a result the intrinsic value remains less than market value.
• Market value includes market fluctuations - market value of company is the current value of company i.e. market value of company = current price of the share in the market * total outstanding shares. Intrinsic value of company is networth of company. Example - asset based approach of evaluating worth of the business calculates the intrinsic value as given below- net worth /intrensic value =common stock +retained earnings -accumulated losses. (Note: an appropriate adjustment made for overvalued and undervalued assets).    In the above method of evaluating net worth, the market fluctuations are not included. Further the current price of share is based on sentiments of shareholders which is also not included in net worth, so the intrinsic value/networth differs from market value of the company.

2. The following techniques of analysis uses the discounted cash flows :   

• Discounted payback period - this method of analysis considers discounted cash flow. Example -

  Year	annual cash flows(a)	dicounting factor@10%(b)	discounted cash flows(a*b)	cumulative discounted cash flows
  1	8000$	.909	7272$	7272$
  2	6000$	.826	4956$	12228$
  3	6000$	.751	4506$	16734$

In the above example discounting factor is used to analyse the investment decision of project. Discounted cash flows are used instead of actual cash flows.

• Net present value (NPV) -The npv technique is a discounted cash flow method that considers the time value of money in evaluating capital investments. NPV= present value of cash inflows - present value of cash outflows. So npv also uses discounting factor.
• Present value index (PI index) - as per this investments are valuated like this, PI = present value of cash inflows / present value of cash outflows. So this technique also uses discounting factor.