A major input when applying modern portfolio theory is expected return. This number can be estimated as the average realized return given some relevant amount of past price history. However, the past is not always a good predictor of the future or expected return. The approach adopted in this lesson is to estimate expected returns using both the spot stock price and the assessed intrinsic value.

The intrinsic value of a firm's stock is traditionally stated as the present value of future dividends discounted back at the cost of equity capital. Two different estimates of dividends are possible. The first is the traditional legal/accounting concept of dividends being represented by dividends paid from a firms retained (accounting) earnings. The second, uses the economic/free cash flow to equity concept of dividends. In this lesson we focus upon the second approach, the use of free cash flows to equity, to compute the intrinsic value and then the expected return from a stock.

The lesson works through the problem of estimating the expected return from IBM stock. To proceed click on the relevant part as listed below or just work sequentially through the lesson:

Lesson Plan

Expected Returns, Free Cash Flow to Equity and Intrinsic Value

Estimating free cash flow to equity

Setting up the two stage abnormal growth model for IBM

Estimating the cost of equity capital

Estimating Intrinsic Value and Expected Return

Sensitivity Analysis