Question

Celine is an analyst for a money management firm. She is asked by her supervisor to estimate the intrinsic value of the common stocks of Pacific Basin Corporation (PBC), so she collects the following information on PBC.

Year
Dividend per share
2019     $1.2
2020     $1.5
2021     $1.8
2022     $2.2
2023     $2.4

She forecasts that the price/earnings ratio for the year 2024 will be 20. In addition, the forecast earnings for the year 2024 are $6.4 per share. The expected market return is 10% and the risk-free rate is 3%. The variance of returns on the market index is 0.3 and the covariance of returns on PBC’s stocks and the market index is 0.45. The weighted average cost of capital of PBC is 10%.

After collecting the information, Celine starts to estimate the value of the common stocks of PBC. Here is the summary of her estimation.

WACC = 10%
Price (2024) = 20($6.4) = $128
Intrinsic value (2017) = 1.2/1.1 + 1.5/1.12 + 1.8/1.13 + 2.2/1.14 + 2.4/1.15 + 128/1.16
= $78.93
As the current market price is $75 per share, which is less than the intrinsic value of the stocks of PBC, it is recommended to buy PBC’s stocks

d State one advantage and one challenge of the method you suggested in part (c).

Answer 1

Advantage of using intrinsic value of shares to decide whether to buy, hold or sell shares of a company:

There are number of advantages of using intrinsic value per share to determine the course of action for an investor in an organization. However, the most significant advantage of all is the following.

The intrinsic value of a share is either calculated by multiplying the earnings per share of the organization with the price earnings ratio. In this case the intrinsic value of $128 per share has been calculated by (6.4 x 20) = $128. Thus, the earnings available to the common shareholders is given the priority. Considering that the investors are mainly concerned about the earnings available to them it is an appropriate method to reflect the actual value of the shares of an organization. Thus, the investors would be in better position to decide whether to buy, hold or sale the shares of the company.

Disadvantage of using intrinsic value of shares to decide whether to buy, hold or sell shares of a company:

Since, the intrinsic value takes into consideration the earnings aspects only and not the dividend which is the proportion of earnings distributed to the shareholders thus, it is not an appropriate method to determine the value of shares of an organization to the shareholders. Since, the investors are mainly concerned about the amount of dividend hence, use of intrinsic value of pose a definite challenge to the investors to correctly decide whether to but, hold or sale the shares of an organization by comparing the market value of the share with the intrinsic value.