A handy valuation technique

Hey my readers, I decided this time to treat you all with a valuation technique that I have just learnt. Hopefully you all are able to apply it to shares and start seeing which type of shares are undervalued or overvalued. I learnt this formula while reading and soon had it all worked out, or so I hope.

The formula is as follows:-

The intrinsic value of a share = Return on Equity/Pre-tax Required Rate of Return * Equity per share

Lets try to break it down further. The intrinsic value of share, some of you might be asking what is that? The intrinsic value means the face value of a share that is worth today for that particular company. This is how much the share is really worth today, irrespective of what the market thinks of its price. So, when the intrinsic value of a share is higher than the market price, we should buy the share. If the intrinsic value of a share is lower than the market price, now there is a difference, we shouldn't sell the share just because the market is trading at a premium to its intrinsic value. We will talk about the topic of selling another day.

Return on Equity is the return on shareholder's funds from the company's profit. It is a measure of dollar for dollar. How much you would get back from the business by investing a dollar into it. The ROE figure cannot be looked alone, it must be looked for a few years' financial performance of a company. Looking back 3-5 years of data, we are able to gauge the company's ROE much better.

The pre-tax required rate of return is what you would want to pay for the share at today's price. If you want a rate of 15% pre-tax return on your money, then this figure should be 15%. I hear you saying then that the intrinsic value of a company depends on how much each person is willing to pay for the share, so it is different for different people. Absolutely right. The intrinsic value of a share depends on the person. This figure can also be obtained by looking at it via opportunity cost. What is the second highest return you can get from another asset? Then putting a risk premium for the shares of the company on top of the second highest opportunity, you can get your required rate of return realistically.

Remember that when we are buying a company, we are buying what is left over of its assets after taking over all liabilities, in other words we are buying the equity of the company. That is why I take equity per share. In other words, the whole formula shows how much is the equity of the company really worth. There are a few assumptions to this model though, that is, this assumes that the ROE of the company, the required rate of return and the equity of the company stays the same throughout the whole time. What you are paying today already takes into account the future worth of all that. All earnings are also paid out as dividends. So remember, using that formula takes into consideration all these.

But nevertheless, if its new to you, it might be fun experimenting with it on companies in the ASX, perhaps. This is one good way of how to value a company's shares. If you invest like Warren Buffett, you might even want to add a margin of safety. That is, only buy shares whose intrinsic value is at a certain discount to the market price. Good luck investing!