Every share of stock has an intrinsic value, which is independent of its current market price. At any point in time, the market price may be roughly equal, significantly higher, or significantly lower than the stock’s intrinsic value. In cases where the two diverge meaningfully, investment opportunities arise.
The purpose of the Intrinsic Value Estimator is to illustrate some principles of a proprietary model used by Diamond Hill as one of the tools to assess the intrinsic value of common stocks. The Intrinsic Value Estimator is a simplified version of the actual model used by investment analysts at Diamond Hill.
The Intrinsic Value Estimator provides a framework to estimate the intrinsic value of a common stock. The intrinsic value is the present value of all the future cash flows over a given time horizon. Using a five-year time horizon, the cash flows consist of any dividends paid during the five-year period and the proceeds of a sale of the stock at the end of year five. The key factors in determining the value are:
- Normalized earnings and earnings growth rate
- Payout ratio and dividends
- Terminal earnings multiple
- Required rate of return
We believe if rational and reasonable assumptions are made on the above factors, the model is useful in assessing the intrinsic value and the expected return for a given stock. Hence, the results of this model are only as good as the assumptions used to derive the intrinsic value.
The Intrinsic Value Estimator is only a tool to estimate the value of common stocks and the output is completely dependent on the inputs. The output of the model does not in any way constitute an investment recommendation of any sort, and Diamond Hill will not be liable for any action I may take based on the results of the model. I have read this introduction and understand the key factors and limitations associated with the use of the model.