Question

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.

Add your references

Answer 1

(1): Intrinsic value of a stock can be computed using different methods like DCF (discounted cash flows), dividend discount model etc. Now some reasons why intrinsic value of a stock might be different from the price that the stock trades in the market are:

Intrinsic value is an estimated value of a stock while market value is the price at which stock is currently trading in the market. Thus the market value can be higher than the intrinsic value (in which case the stock is deemed to be overvalued) and can be lower than the intrinsic value (in which case the stock will be deemed to be undervalued). Now computation of intrinsic value involves several assumptions and use of various different variables. As such intrinsic value computation is very difficult and it cannot be said the intrinsic value computation is always spot on and hence we see that different analysts have different intrinsic value computations for different stocks. For instance in the DCF method the assumptions are with regards to growth rate, cost of equity, growth after the horizon period, etc. Any slight deviations in these variables or in the assumptions will cause the intrinsic value to differ.

(2): Three different examples of analysis where discounted cash flows are used are:

• Computation of intrinsic value of a stock – here free cash flows are discounted with the weighted average cost of capital to compute intrinsic value of a stock.
• Net present value analysis – This is applicable in case of capital budgeting in which cash inflows and outflows are discounted at required rate of return to compute the net present value of a project.
• Dividend discount model – Here the cash inflows from dividends are discounted with required rate of return to compute intrinsic value of a stock.