8.9  Assessing Intrinsic Value

In this section you will learn how to estimate the inputs required for the RIV Model.  Learning is by doing and you will work directly with actual data on file with the SEC for IBM.  By the end of the exercise you should be comfortable with the operational details.

Concept 1 (Book Value per Share): 

The firm’s investment and dividend decisions determine the book  value per share.  The book value per share represents the shareholders’ investment in the firm.  Book value per share is simply value of the shareholders equity divided by the net shares (i.e., shares issued less Treasury stock) outstanding. 

Concept 2 (Cost of Capital): 

The discount rate used to compute the present value of future residual earnings per share is the stock’s cost of equity capital.  The firm’s financing decision provides one driver of this discount rate in addition to capital market constraints.  Combined the cost of equity capital equals the return required by investors in the capital markets.

Concept 3 (Future Residual Earnings Stream):  

This concept is designed to capture the value added to book value per share that results from assessing the firm’s investment and financing decisions.   Residual Earnings at time t is defined as Comprehensive Earnings at time t – Investors’ Required Rate of Return (= Cost of Equity Capital) * Beginning period book value. 

To project residual earnings into the future the second important input for this concept is assessed growth behavior of the book value per share.  This allows residual income to be projected out over time by growing at the assessed growth rates.  Under these projections if residual earnings are expected to be positive over time then intrinsic value will exceed book value and vice versa.

Estimating Book Value per share using a 10-K Statement

In the next section we formally apply this model to IBM starting with estimating the book value per share.  This implementation of the dividend model for intrinsic value starts by anchoring value at the book value per share.  Book value per share is defined as the total assets divided by total net shares outstanding. 

In chapter 1 you learned how to access the financial statements into a spreadsheet and one of those statements was the Consolidated Statement of Stock Holders Equity.  This statement is especially important the concept of Comprehensive Income as we will see later but it also contains the book value of Stockholder’s Equity: