Expected return/Intrinsic value/Required return help

This is regarding return concepts and section 2.4 in reading 29.

Expected return = required return + convergence to intrinsic value (good so far)

from page 51 of equity book:

“To illustrate, in august of 2013, one estimate of the required return for Toyota Motors shares was 6.3%. At a time when Toyota’s ADR market price was $127.97, a research report estimated the company’s intrinsic value at $176.30. Thus, in the author’s view, Toyta was undervalued by V0 - P0 = $176.30 - $127.97 = $48.33, or 37.77% as a fraction of market price. If price were expected to converge to value in exactly one year, an investor would earn 37.77% + 6.3% = 44.07%.”

This I do not understand. If the price converges to the analyst’s intrinsic value in a year, the return would just be the 37.77%, would it not? I get that the required return is 6.3%… but it seems like that is already accounted for in the intrinsic value that the analyst is forecasting, so the alpha should be 37.77% - 6.3% = 31.47%. If the required return is 6.3% then the share should be expected to rise by that amount anyway, no?

Any help on this? Feeling dense.

The assumption is that the intrinsic value is growing at the required rate of return. So the intrinsic value is $176.30 in August, 2013, but in August, 2014 it has grown by 6.3% to $187.41.

Note, too, that their formula of adding the two returns is an approximation (and in this case, a lousy one) they should be compounded.

Thanks for the reply.

That makes some sense… but it seems like it is saying that the stock is perpetually undervalued by the required return of equity. That can’t be correct, right?


They’re saying that in August, 2014, the market price will have converged to the _ 8/14 _ intrinsic value of $187.41.

The actual return is $187.41/$127.97 − 1 = 46.45%

Note that (1 + 37.77%)(1 + 6.3%) − 1 = 46.45%. As I wrote above: the two returns should be compounded, not merely added.

Excellent, that is very clear. Thanks

You’re welcome.

What is the formula to find the annual return?

The intrinsic value per share is $137.33 at a 6.61% annual discount rate

Based on the cash flows you have forecasted and a market price of $90.52, this company may yield a 8.37% annual return

Perpetuity growth rate is 2,5%