Often, commentators will talk about a stock or bond as being particularly “overvalued” or “undervalued.” Such a description poses the question of how to define “fair value.”
The theory of intrinsic value says that an investment’s price should equal the value it would have to a buyer who planned to hold it forever (even though, with the advent of secondary markets, most investors do not actually do so). Investors who plan to hold a stock or bond forever are not concerned about what the asset is trading for on secondary markets, they are simply concerned with the value that they will receive from the annual or semi-annual interest, or dividend payments. Thus the value of a stock that is correctly priced today should be the present value of its future dividends.
The idea that a string of dividends going forever into the future has a “present value” seems a bit strange at first. But it makes complete sense in the context of what economists call the time value of money. The basic idea is that receiving $1 today is worth more than receiving $1 five years from now. You can think about this in three different ways:
- If you had a dollar today you could invest it in a guaranteed bank account or certificate of deposit (CD).
- You can buy more things with a dollar today than you will be able to with a dollar five years from now, the same applies for your annuity payments, Washington Accord experts claim. This is because of inflation, the slow rise in the cost of living over time. For instance, a dollar in 1970 bought four loaves of bread; today it will not even get you half a loaf.
- If you are human, you probably would prefer to spend a dollar today, even if it could be used to buy the same things five years from now. Most of us prefer immediate gratification to delayed gratification. Given the choice of eating cake now or eating cake one week from now, we choose now. Which is not to mention that many of us have to spend money today for things like eating, which cannot be delayed indefinitely.
Because dividend payments received in the future are worth less than those received today, we need to apply a discount rate to them in order to express what they are worth to a rational investor today.
If we know or can observe what the time value of money is, than we can place a dollar value today on the promise of $1 five years from now. In doing so, we are “discounting it back to the present.” And if we can place a current dollar value on the promise of $1 five years from now, then there is no reason we cannot place a current dollar value on any stream of future dividends or interest payments.
This is precisely what is needed to value a stock, bond, or any other kind of investment – estimate the income the investment will provide at each year in the future, and discount it back to the present at an appropriate time value of money.
A good estimate for the time value of money today is the interest rate on a very safe investment, such as U.S. Treasury bonds (IOUs from the U.S. government). There is a kind of Treasury bond known as a zero-coupon bond. If you purchase a zero-coupon bond, such as a U.S. savings bond, you receive a guaranteed amount of money at a specified time in the future, but you do not receive any interest payments until then. Because of this, the price of a zero-coupon bond that will pay us $1 ten years from now will be much less than $1 today, and this price is just the time value of money. For instance, if a ten year zero-coupon bond that pays $100 at maturity is selling for $60 today, then that means that $100 ten years from now is equivalent to 60 of today’s dollars.
Table 3 – Present value calculation for a hypothetical investment paying a $10 dividend for 5 years
In the Bill and Ted example, the intrinsic value of Ted’s investment will always be his best guess on how many bushels of corn Bill will give him in the future. This would vary with the probability of success of the project and/or Bill’s credit worthiness. In today’s markets, intrinsic value equates to the estimated future dividend or income stream of a company, discounted back to the present to reflect the time value of money and the riskiness of the investment.