Course: Investment Planning
Lesson 5: Fundamental Equity Analysis
The first Review Exercise page in Lesson 5 – is Intrinsic Value the same as Risk Premium? Is that why we’re solving for P0 and not V (which is given)? The formula provided in the explanation confuses me. (question and answer from Review Exercise below)
Review Exercise Question:
- Given the following information, what did this investor assign as the risk premium for ABC stock?
Current price of ABC stock = $25
Intrinsic value of ABC stock = $20
Last ABC dividend = $3
Risk-free rate = 3%
Dividends will remain constant
- Not enough information
Review Exercise Correct Answer Feedback:
Correct. Based on the information, you should have been able to determine that the required rate of return was 15%.
Po = Do/k
20 = 3/k
K = .15
After subtracting the risk-free rate, the risk premium of 12% remains.
The risk premium is the additional return an investor demands to take on more risk than the risk-free rate of return. For equity securities, you may see this referred to as the equity risk premium.
A security’s intrinsic value is the theoretical value of a security based upon the net present value of its cash flows.
- To calculate NPV, we must have a discount rate.
- The discount rate is equal to the required rate of return.
I say “theoretically” because investors routinely pay more or less than intrinsic value. For example, a market price below intrinsic value implies the security is undervalued in the market and may be a “buy signal” for investors. A market price above intrinsic value implies the opposite – the security is overvalued in the market may be a “sell signal” to investors holding the stock.
Based on the fact pattern and using our constant rate dividend model, we determine that the investor’s required rate of return is 15%. The investor demands 12% more return than the risk-free rate of 3% to invest in this security. An example of calculating required return is presented in the “Zero-Growth Model” discussion in your lesson. From there, you would only subtract the risk-free rate to determine the risk premium. On the CFP Board Exam, a student may be called upon to calculate P0 , D0 or k given any two of these three variables.
Onward and Upward,