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P/E multiple that gives the expected value of earnings at the end of 2008 as 15 368, or $5520 per share The present value of $5520 depends on the discount rate assumed I think of the discount rate as the minimum rate at which I would be comfortable owning a part of the company s business The discounted value of $5520 in 1998 at the discount rate of 7 percent (a low rate, but an assumption based on the mortgage rate I was paying at the time) is $2806 per share If Coca-Cola was not paying any dividends, that would be one estimate of the intrinsic value of Coca-Cola at the end of 2008 (or in early 1999 when 1998 year-end accounting data became available) We should add the value of dividends at least for the amounts expected to be received during the following 10 years The cash dividend in 1998 was $060 per share Assuming a 10 percent growth rate in dividends (similar to the growth rate in earnings), an investor would have received $066 in 1999, and so on Using a discount rate of 7 percent, the discounted value of the next 10 years dividends is $983 per share Therefore, my estimate of Coca-Cola s intrinsic value in 1999 was $2806 + $983 = $3789 In the fall of 1999, when I made these calculations in a class I was teaching, the stock price was about $70 per share Based on these calculations, Coca-Cola stock seemed overvalued by almost 100 percent Note that we estimated that in early 2009, the Coca-Cola stock price would be around $5520 per share In early 2009, the Coca-Cola stock price was $45 per share; and the P/E multiple, based on trailing 12 months earnings, was 18 You can add many other changes and complications For example, you could argue that we should value dividends differently from earnings because dividends are being paid out while earnings are not You could have simply used the dividend discount model generally attributed to Myron Gordon4 Overall, depending on assumptions, you could have produced substantially different estimates of Coca-Cola s intrinsic value in early 1999 A few additional comments on the analysis are worth making CocaCola is a stable company, so it is relatively easy to estimate future earnings The possibility of you going very wrong is low Given that there are far too many uncertainties for high-tech companies, you should think more
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carefully about their future earnings before you compute intrinsic value in a similar manner Even Coca-Cola s stock price uctuated by a factor of two between 1998 and 2009 It has seen a low of less than $40 per share and a high of more than $85 per share So if you do not have a long-term view and do not have suf cient liquidity, you may not achieve your goal of reasonable returns with any company s stock For example, if you suddenly need funds and are required to sell when the price is low, you might lose a substantial amount of your original investment even if you invest in CocaCola, let alone in stocks of companies with less predictable earnings There is another advantage to computing intrinsic value It keeps you grounded so that you do not become nervous when the stock price goes down As a matter of fact, I considered buying Coca-Cola stock when the share price was around $40, down from $85 But I did not because intrinsic value estimates still did not justify buying A check: While I was assigning a 15 to 20 P/E multiple to CocaCola s stock, I wondered why the P/E multiple in early 1999 was $70/142, or about 49 It could have been 25 or even 30, but why did the stock command a high P/E of 49 Around then, the market was assigning high valuations not only to Coca-Cola but also to a host of other stocks, especially Internet stocks These stocks were boats that were being lifted in a rising tide What can we learn from this You could say, The market was wrong, but for me, unfortunately, that is never a satisfactory answer I would ask, Why was the market wrong I simply do not have a satisfactory answer to the question, Why was Coca-Cola s stock price so high Nevertheless, when it does happen, it is best not to buy
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