Hi
Lets suppose a stock is currently trading at its intrinsic value of $100 and the required return on equity is 10%. The reading on valuation concept implies that the target price at the end of the year will be 100*1.10 = $110 (assuming no dividends). My question is why would someone, after a year, pay $110 to buy the stock when its true value is only $100? I’m I missing something from the logic of required return or intrinsic value?
After a year its true value isn’t $100; its $110. Its true value is $100 today, not one year from today.
If it earns 10% during the year, then it’s value after a year will be V0 * 1.1, naturally. Since all of the earnings are ploughed back in the company ($10).
right…so the price targets we see in equity research reports are based on cost of equity? assuming the stock is currently fairly valued
They should be, yes.
Stock price and targets are mostly a function of past earnings, revenues, and prospects for growth. Sales and earnings forecasts are the crux of most eqy valuations. Discount rate, or required return on eqy also play a factor, with higher rates applied to riskier investments, but it’s not the main dirver of valuation and price targets. Revenue and earnings drive stock prices and forecasts. Required return on equity is based on the risk free rate, beta or volatility, and equity risk premiun. A stock is ‘fairly vaued’ when the price equals the discounted value of future cash flows, but since those are subject to varying growth and discount rates, fair value prices will not be uniform.
No, it’s based on market pricing inefficiencies primarily.
The recommendations are usually overweight, neutral, underweight. Or less commonly, Buy, hold, sell.
The target price is the difference between market price and fair value, whether that is on the upside or downside. The research included inside the report can give you the information you need to decide whether that is a good stock to invest in on the long term as part of your portfolio.
but what if the stock is trading at its intrinsic value? Should we expect the stock to increase in price a year from now?
Yes.