 Oh, and welcome to this session. This is Professor Farhad in which we would look at the intrinsic value of a stock versus its market price. This topic is covered in an essential of investment course or the CPA exam, BEC section, as well as the CFA exam. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have close to 2000 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them and share them. On my website, farhadlectures.com, you will find additional resources, especially if you are studying for your CPA exam, or if you would like to complement and supplement your accounting courses. Look, I do not replace your CPA prep courses. I do not replace your Becker, Roger, Wiley, and all these courses. I help supplement those courses. So check out my website. So what we need to look at first is how to value a stock. Well, how do we value a stock? How do we value a security, especially a stock? To return on a stock investment, I hope we know this comprise of two things, comprise of cash dividend and capital gains or losses. So when you buy a stock and we're assuming it's a dividend paying stock, what do you expect? You expect that you get dividend back and you'll get some capital appreciation. The stock goes up, which is called the capital gain. You could also, the stock could go down and you could have a capital loss. But those are the two main components of your return on investment. So let's try to compute this return on investment. So let's assume one year holding period and let's assume we have an ABC stock with an expected dividend per share, the expected D of 1, $4. And usually companies will declare their expected dividend or they would have a growth rate where you can compute this expected dividend. So this is the cash dividend that's expected. The current price P0, P0 is today. The price today is $48 and expected price, which is, we don't know the expected price. That's why it's called the expected price is 52. At this point, we would like to know if this price is attractively priced. Is this a good stock to buy? Well, what do we need to know? We need to know if we buy the stock, what will be our holding period return. And we should know how to compute this from prior chapter. The output will take 4 divided by 48. This is the $4 dividend. So this is the dividend rate, 4 divided by 48. And we'll take the ending price minus the beginning price, which is the difference also of $4 divided by 48. And this is called the capital appreciation rate. So we have a dividend rate and capital appreciation. Together, they will give us 16.67. In other words, the expected rate of return on this stock is 16.67. Remember the $4 both if you divide this by 2, you will find the dividend rate versus the expected rate. But what is the required rate of return of ABC stock? Now we know if this is, if this holds true, we would earn 16.7. But the question is, what is the required rate of return of this stock? Well, how do we compute this required rate of return? Well, we could use here, we could go back to the capital asset pricing model. Hopefully we remember this. If not, please go to my playlist and find the capital asset pricing model. Basically state that the stock prices at equilibrium level, the expected rate of return on any security equal to the risk free rate, plus its beta times the risk premium. Hopefully you know this. So cap M can be viewed as providing an estimate of the rate of return required, of the rate of return an investor can reasonably expect to earn on a security given its risk measure by its beta. So cap M is one measurement. So we say, what's the cap M of the stock? We know based on our holding period, the stock would return 16.67. But what's the, what does cap M tells us? Well, we're going to donate this required rate of return SK. This is the required rate of return. We're going to represent this by K. So if the stock is correctly priced, if the stock is priced correctly, it will offer an investor a fail return, which is what you expect will equal to the required. Simply put, this is what cap M basically gives you. What you expect should be equal to your required. And the stock will say it's fairly priced. But of course, when we do financial stock analysis, we want to find the mispriced stock to be better off. So the goal of a security analyst is to find the price, if this find stocks that are mispriced, if they are undervalued by them, if they're overvalued, we short them. For example, an underpriced stock will provide an expected return. You expect a greater than the required rate of return. Simply the required rate of return. Remember, we can measure this through cap M. If the expected is greater than we should buy the stock because we expect to earn more than the required. So it's underpriced now. So it's basically on a discount, on a sale. So we should buy it. So suppose for the sake of this example, we have risk-free rate of 6%. The risk premium is 5%. Expect the market minus the risk-free rate. And the beta for ABC stocks is 1.2. Now let's find the required rate of return, which is K. Let's do the computation. We find that the required rate of return on this stock is 12%. What do you think? Is this a good stock to buy if our expectation is correct? Of course it is. Why? Because the expected rate of return is 12 based on the cap M. The required return is 12, but the expected is 16.67 that we computed on the prior page. Now assume everything materializes. So this is an underpriced stock. So the 16.7 rate of return, the investor expect, exceeds greater than the required rate of return based on ABC's beta by a margin of 4.7, ABC beta, or basically simply put the cap M model. 16.7 is greater than 12 by 4.7. Naturally, any investor will want to include more of ABC stocks in their portfolio. Well, another way to say the same thing is to compare the intrinsic value of a stock versus it is market price. So simply put, the intrinsic value is what I think the stock should be worth versus its market price. Market price what's giving right now. So how do we compute the intrinsic value? Well, this is a new computation donated by V of zero. It's the intrinsic value of a share of stock is defined as the present value, PV, of all cash payments to the investor in the stock, including dividend as well as proceeds from the ultimate sale of the stock, discounted at the appropriate risk adjustment interest rate. Simply put, you will discount the future dividend, which is the future payment, and you will discount the price of the stock to the present value, and this will be the intrinsic value of the stock. Now, again, we always know the dividend or we should know the dividend, but the price we don't know, we can estimate. So whenever the intrinsic value or the investor own estimate of the stock is of what's really worth exceeds when the intrinsic value, what we think it's worth, greater than the market price, what is it today, the stock is considered undervalued and it's a good investment. Okay, so again, for ABC using one year investment horizon and a forecast that the stock will be sold at $52. So what is the intrinsic value of the stock? Well, we can find the present value of the dividend plus the present value of the stock. So the expected dividend is $4 plus the expected price of the stock 52, discounted divided by one plus the discount rate of 12. We'll find out that V of zero, the stock is worth $50 today. So this is the intrinsic value of the stock. It should, what is it worth? What it should be worth today based on the future dividend and the future price of the stock. So another way to look at this is just to make sure we understand how we compute that it's only 12%. Another way to look at this is the dividend rate, which is the dividend is $4 divided by $50 divided by $50 plus if the price today is 50 and it's gonna be 52, the difference is $2, two divided by 50. So here's what's gonna happen. Four divided by 100 is 4%, four divided by 50 is 8%. So this is 8% plus two divided by 100 is 2%, two divided by 50 is 4%. So notice we confirm actually, it's correct. I mean, this is just a confirmation. So the actual price of ABC today is not 48. The actual price of ABC is 48. Therefore, ABC is a good buy. Why? Because the actual price is 48 based on the intrinsic value, it should be 50. So in addition to the 12%, we could earn an additional $2 which will make the expected return 16.67. And that's why this was a good buy. This is a good buying stock. And this is in the terminology of CAPM, this is a positive alpha stock and the investor will want to buy more of it to have in their portfolio. Now we're gonna have a term called market capitalization rate and market equilibrium, the current price should reflect, will reflect, not should, will reflect the intrinsic value estimate of all market participant if the market is an equilibrium. This means the individual investor whose intrinsic value V zero estimate differs from the market price in effect might disagree with one of the factors that we are computing. It's either they disagree with the expected dividend, they disagree with the expected price of the stock or the required rate of return, which is K. Now a common term for the market consensus value of the required of return K is called market capitalization rate. And we will be using this in future, in future lectures. Now let's make sure we can compute this those basic computation which we're gonna be needing in the next chapter in the next lecture, not next chapter. You expect the price of IBX to be 59.77 per share a year from now. Its current price is 50 and you expected to pay dividend one year from now of $2.15 per share. What are the expected dividend yield rate of price appreciation and the expected holding period which is the expected holding period is the dividend yield plus the rate of price appreciation. Well, let's start with the dividend yield. The stock will pay $2.15. The stock is worth today, we can buy it at $50. This is gonna give us 4.3 dividend yield. Now, what is the price rate of price appreciation? Well, the price that's gonna be $59.77 a year from today minus $50, so we're gonna have $9.77 in price appreciation divided by 50 and that's gonna give us 19.54. This is gonna give us 19.54. Therefore, what's the expected holding period? It's this number plus this number which is dividend yield or dividend return plus 19.54 equal to 23.84. This is the expected holding period. If the stock, now if the stock has a beta of 1.5, risk free rate equal to six and the expected return, expected rate of return of a market portfolio is 14, what is the required rate of return on IBX or K? Here we're looking for K, the expected rate of return. Simply put, what we do is we say, well, we use the CAPM model, risk free rate, which is 6%, plus the beta of the stock, which is 1.15 times the risk premium, which is, what's the risk premium? We have the portfolio is 14% minus, minus risk free rate of 6%. So if we compute this, if we compute this, we find out that K, which is this is K, which is the required rate of return, K equal to 15.2. Whoa, would you buy this? Oh, well, what is the intrinsic value of IBX stock and how does it compare to the current market price? Before we answer this question, will you buy the stock? Of course I will because the expected return is 15.2, but the K equal to 15.2, but we expected to earn 23.84, definitely will buy it. What is the intrinsic value of the IBX stocks and how does it compare? What's the intrinsic value? We have to discount the future payment, which is $2.15, plus we have to discount the future price of the stock, which is $59.77 based on 15.2, 15.2, which is 1.152, which is 1.15. And this is gonna give us an intrinsic value of $53.75. So this is the intrinsic value, 53.75. So we think the price should be 53.75, but the price actually is how much? The price actually is 50. Should we buy the stock? And the answer is yes, because the intrinsic value is higher than what's the current price today. So if we buy it right now, we should kind of think of it as it's undervalued by $3.75, which is a decent amount rate of return, which is the difference between, if you think about it, it's the difference between 23.84 minus 15.2. The difference in the percentage, this is the extra $3.75. In the next session, we would look at the dividend discount model. Again, this topic will be covered on the CPA exam BEC section. If you like this recording, please like it and share it. As always, I'm going to invite you to visit my website forhatlectures.com, especially if you are an accounting student. Your CPA is a long-time investment in your career. Take it seriously, put the exam behind you, focus on your career, good luck, study hard, and stay safe.