The most common method in academics to find the intrinsic value of a company is using Gordon growth model. However, this method isn't without its drawback. The biggest challenge we need to face is making correct assumptions. We have to find two variables: Discount rate(WACC) and growth rate. In general, the discount rate can be calculated by using company's financing structure and the growth rate is set to be higher initially and then lower to the normal growth of the economy in the end. Let's talk about WACC. By definition, WACC is minimum rate of return in the eyes of investors. It is a good thing that ROE(return on equity) is higher than WACC. However, it will not be sustainable. It is human nature that people like to invest money to a company which can generate higher profits than any other companies.
- If ROE > k, the V(stock price) is increasing. In this situation, the higher the growth rate is, the higher the V will be.
- If ROE=k, the V stays constant no matter what the growth rate is.
- If ROE
If the first situation holds, people will most likely invest in this company as much as possible.
Under competitive market assumption, ROE will eventually fall into the one of industry average, which is close to WACC.
Likewise, growth rate of a company can't be At a high level forever. If a company is growing higher the the economy. That company will become the whole economy, which is impossible. So we usually set growth rate same as GDP growth.
So when we try to find a undervalued stock, we take these things into consideration.