The Thoughtful Investor
Intrinsic Value – Theory And Practice
This section discusses the theory of intrinsic or fair value as computed using the discounted cash flow method, how it differs from the actual price, and why price and value rarely equal each other due to the dominating factor of emotion in stock price discovery.
The author says that John Burr Williams stated that the intrinsic value of a stock equals the discounted value of future dividends plus the residual value of the business. In other words, one had to predict the future dividend payoffs and then bring it to present value by discounting it with an appropriate number.
Discounting is the process of equalizing the purchase power of a rupee to be received later in the future to its current value. For example, if prices are expected to rise every 10% every year then the value of the goods and services that can be bought for ₹100 one year later would need only ₹90.90 to be purchased today.
In case a company is not paying dividends as per Williams, the intrinsic value should be the future payoffs when the company actually starts paying dividends, whereas companies that retain and invest a large part of the present cash flow for future payoffs, the intrinsic value will be the present value of the residual cash whenever the company is ultimately liquidated.
The above argument basically suggests that a company which does not pay a significant amount of dividend in the current phase should pay higher dividend in future if this is to be valued ahead of a company that is paying dividends and that companies that do not generate enough surplus for distribution to their shareholders should be valued lower.
That is primarily the reason why cash guzzling, asset heavy, and negative cash flow companies like cement, steel, oil and gas etc. are valued cheaply to the cash distributing asset light businesses like consumer pharmaceuticals, and IT Services.
The author says that ultimately the price of a stock is governed by what the buyer is willing to pay and not by what he/she actually pays or by what a seller is willing to take and not by what he/she should actually take.