Stocks traded in the secondary market have a price that is formed from investors' bid and offer. The price can move up or down because it is influenced by factors such as macroeconomic conditions, company performance, and the sentiment of market participants. Therefore, the stock's price in the secondary market can be referred to as market value.
The market value at the time we buy or sell a stock may be different from its intrinsic value, which could be lower or higher. Intrinsic value is the original or true value of a stock that is estimated based on its potential and all aspects that affect the company's business in the future.
There are several formulas to calculate the intrinsic value of a stock, one of the most popular is the Gordon Growth Model (GGM). The formula can be explained as follows.
Remarks:
V₀ = Current intrinsic value of the stock
D₁ = Expected total dividends per share in the next period
D₀ = Total dividends per share for the last period
r = Expected rate of return using the Capital Asset Pricing Model formula (CAPM)
g = Company's sustainable growth rate
r = Rf + β (Rm – Rf )
g = RR × ROE
Rf = Risk-free rate, in this case using BI-Rate (benchmark interest rate)
β = Beta of stock, the covariance of stock & JCI* returns divided by the variance of JCI returns calculated statistically (usually shared online by investment media).
Rm = Market rate of return, in this case using Compounded Annual Growth Rate (CAGR) of JCI
RR = Retention ratio (1 – Dividend payout ratio)
ROE = Return on equity (Net income ÷ Total equity)
*JCI = Jakarta Composite Index (IHSG)
Example of Intrinsic Value Calculation
ABCD stock currently has a price of IDR 3,500 with a beta of 0.3. The issuer recently distributed dividends of 175 per share totaling IDR 18 trillion. Their net income for the period was IDR 25 trillion and total equity was IDR 145 trillion.
Other information includes:
BI-Rate: 6%
CAGR of JCI year 1983 to 2024: 11.2%
To calculate the intrinsic value of ABCD stock using the GGM method, first calculate its dividend payout ratio by dividing total dividends by net income: 18 trillion ÷ 25 trillion = 0.68. We can then get the RR of 1 - 0.68 = 32%. Meanwhile, its ROE is: 25 trillion ÷ 145 trillion = 17.24%.
From here, we can look for the company's sustainable growth:
g = RR × ROE = 32% × 17.24% = 5.5%
The next step is to find the expected rate of return of ABCD stock using the CAPM formula:
r = Rf + β (Rm – Rf )
= 6% + 0.3(11.2% – 6%)
= 7.14%
Finally, input r and g into the GGM formula:
∴ The intrinsic value of ABCD stock is lower than its market value, meaning that the stock is overvalued based on the GGM method.
Considerations for Using the GGM Method
GGM is a logical and objective method of calculating the intrinsic value of stock because it is based on real economic condition so that it is in line with business fundamentals and has minimal subjectivity.
However, it should be noted that the GGM method is only optimally used in established companies in terms of financial stability, market position, and growth. Therefore, the results of the GGM calculation will be less accurate if applied to startups with a high growth orientation.
Another thing that can reduce the accuracy of the GGM calculation is the tendency of companies to maintain the amount of dividends even though income is falling.
Disclaimer: The content is made for educational purposes, not a recommendation to buy or sell a particular stock. PT KAF Sekuritas Indonesia is licensed and supervised by the Financial Services Authority (OJK).