Chapter 6:  Intrinsic Value: The Dividend Model

hat is a stock really worth?  How do you know if a stock price is “too high?”  How do analysts forecast future price targets for stocks, or downgrade and upgrade them?  The answers to these questions require some way to determine a value of a stock separately from the market price.  This value is known as the intrinsic value or the fundamental value.  Other terms that are used are “fair value” and “fair market value” though we will not use these because they also have other interpretations.  For example, FAS 157 defines fair value as “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date,” so this embodies the notion of a trade, and is thus a “market price.”

The intrinsic value of a stock is an estimate of the potential value of the stock, whether or not the stock trades at that price.  If you believe that markets are efficient, you may feel that the only relevant estimate is the price.  But markets can be wrong; in fact, in 2008, the former Chairman of the Federal Reserve Board stated in a congressional hearing that "he had put too much faith in the self-correcting power of free markets…." Edmund Andrews, New York Times (October 23, 2008).  The self correction referred to in the quote is the notion is that if the market price strays too far from the intrinsic value, the market will correct itself.  The statement already presupposes that there is an intrinsic or fundamental value, the debate being more about whether market prices reflect this intrinsic value correctly.

The next example shows you very clearly that market assessments can differ from intrinsic value.