Well, to recap, the intrinsic value of a stock or an investment is its true or inherent value based on some valuation method. For more on its concept, pls refer to my previous post on intrinsic value. In this post, I shall attempt to calculate the intrinsic value of some stock using PER and EPS. Now please understand this is like saying Singapore under 16 Basketball Team is trying to beat NBA All Stars, i.e. it is impossible but we like your spirit, so please go ahead and malu yourself.
Anyway, the idea behind is actually quite simple. Basically you must first have an idea of what is the true PER of the stock, and what is its potential EPS, say 5 yrs down the road. Then you can multiply PER by EPS and get the intrinsic value or target price. (Yes this is the dreaded target price given by analysts, and yes, none of them ever got that right and most likely, yours truly here won't get it as well.)
For those still blur, don't worry, here's the formula
PER = Share price / Earnings per share (EPS)
if we swap the formula around,
Intrinsic value or target share price = true PER x potential EPS
So, how do we know what is the true PER of the stock? Usually by looking at the market and industry PER. So today, STI trades at 15x PER and the airlines in Asia trade at 20x on average. So we can assume that SIA should trade roughly around this range. Let's arbitrarily assume that the true PER for SIA is 17x.
Next we need to determine its potential EPS. SIA managed an EPS of $1 in 2005. So assuming that it can maintain this level, say 5 yrs later. We have its potential EPS at $1. So to get its intrinsic value (or target price), simply multiply 17 x 1 = $17. SIA should trade at $17. Today it is trading at $15.7. So is it a buy?
Well, the answer is no, because our calculations may be wrong. What if the true PER is 15x? Or what if the potential EPS is only 80c?. If you work if this new set of no.s, (15 x 0.8 = 12) SIA should trade at $12. So how? Suck thumb lor.
Intrinsic value is not just a single number, it has a range of probable values. It changes when we use different assumptions and nobody ever gets it right. I mean NOBODY, not even the Gahmen. That's where margin of safety comes in. For those not-so-familiar, pls read the post on margin of safety.
In a nutshell, if ever SIA trades at $3. Then it is definitely a buy, because no matter how you tweak the two no.s (PER or EPS), you can never get below $3. But SIA will never trade at $3 unless Sept 11 happens on Christmas and New Year in 5 major cities or something. In other words, it is damn bloody difficult to find stock that trades below its probable range of acceptable intrinsic values . This is the challenge and this is value investing.
See also Definition: Value investing
and Expectations vs Reality