Now that all initial inputs have been set up estimating Intrinsic Value and Expected Return is straightforward. Click on Calculate.

In the above example this is 110.37 and 10.86%.

The intrinsic value is computed from the two stage abnormal growth model using the above assumptions. That is, FCFE is assumed to grow for 10-years at the abnormal rate equal to 11.92%, and then in perpetuity at a normal growth rate equal to 6%. The FCFE is 6350.50 and the long term bond rate equals 5.435.

At this time IBM was trading at 121.10. The expected return is computed from this current spot price as the yield to maturity given the future cash flows generated from the Intrinsic Value analysis. This equals 10.86%.

It is interesting to contrast the prediction from CAPM for expected return. In the CAPM equilibrium the cost of equity capital equals the expected return. In the current case this would be: 0.05435 + 1.30*0.05 = 11.93%.

It should be noted that the above estimate for intrinsic value is a first pass. That is, the initial analysis is the starting not finishing point in practice. It is important that you assess key assumptions relative to your understanding of the business, the industry and the economy as a whole that IBM is operating in. This leads naturally to consider how sensitive current estimates are to important assumptions or vice versa what are the important assumptions when trying to assess the intrinsic value of a stock?

In the next topic we provide an introduction to conducting consider conducting sensitivity analysis upon our estimate for IBM.