It is not uncommon to see stock prices gyrate wildly during earnings season. A small earnings beat and the stock goes up 10% or even 20%. An earnings miss and the stock is down double digits after hours.
Are these stock price movements justified? Has the intrinsic value of the stock really changed that much? In this article, I look at how a change in assumptions about a company’s cash flow can affect the intrinsic value of the stock.
I take a look at what effects changing assumptions to a company’s cash flow have on the intrinsic value of the stock.
When long-term assumptions are slashed
Let’s start by analysing a stock that has its long-term assumptions slashed. This should have the biggest impact on intrinsic value compared to just a near-term earnings miss.
Suppose Company A is expected to dish out $1 in dividends every year for 10 years before it closes down in year 10 and liquidates for $5 a share. The liquidation value is paid out to shareholders as a special dividend in year 10. The table below shows the dividend schedule and the calculation of the intrinsic value of the stock today using a 10% discount rate.
| Year | Dividend | Net present value |
| Now | $0.00 | $0.00 |
| Year 1 | $1.00 | $0.91 |
| Year 2 | $1.00 | $0.83 |
| Year 3 | $1.00 | $0.75 |
| Year 4 | $1.00 | $0.68 |
| Year 5 | $1.00 | $0.62 |
| Year 6 | $1.00 | $0.56 |
| Year 7 | $1.00 | $0.51 |
| Year 8 | $1.00 | $0.47 |
| Year 9 | $1.00 | $0.42 |
| Year 10 | $6.00 | $2.31 |
| Sum | $15.00 | $8.07 |
The intrinsic value in this case is $8.07.
But what if expectations for Company A are slashed? The dividend schedule is now expected to drop 10% to 90 cents per share for the next 10 years. The liquidation value is also cut by 10% to $4.50. The table below illustrates the new dividend expectation and the new intrinsic value of the stock.
| Year | Dividend | Net present value |
| Now | $0.00 | $0.00 |
| Year 1 | $0.90 | $0.82 |
| Year 2 | $0.90 | $0.74 |
| Year 3 | $0.90 | $0.68 |
| Year 4 | $0.90 | $0.61 |
| Year 5 | $0.90 | $0.56 |
| Year 6 | $0.90 | $0.51 |
| Year 7 | $0.90 | $0.46 |
| Year 8 | $0.90 | $0.42 |
| Year 9 | $0.90 | $0.38 |
| Year 10 | $5.40 | $2.08 |
| Sum | $13.50 | $7.27 |
Understandably, the intrinsic value drops 10% to $7.27 as all future cash flows are now 10% less. In this case, if the stock was trading close to the initial $8.07 per share intrinsic value, then a 10% decline in the stock price can be considered justified.
When only short-term cash flows are impacted
But most of the time, expectations for a company should not change so drastically. An earnings miss may lead to expectations of lower dividends for the next couple of years but does not impact dividend projections for later years.
For instance, let’s say the dividend projection for Company A above is cut by 10% for Year 1 but returns to $1 per share in Year 2 onwards and the liquidation value at the end of Year 10 is still $5. The table shows the new expected dividend schedule and the intrinsic value of the stock.
| Year | Dividend | Net present value |
| Now | $0.00 | $0.00 |
| Year 1 | $0.90 | $0.82 |
| Year 2 | $1.00 | $0.83 |
| Year 3 | $1.00 | $0.75 |
| Year 4 | $1.00 | $0.68 |
| Year 5 | $1.00 | $0.62 |
| Year 6 | $1.00 | $0.56 |
| Year 7 | $1.00 | $0.51 |
| Year 8 | $1.00 | $0.47 |
| Year 9 | $1.00 | $0.42 |
| Year 10 | $6.00 | $2.31 |
| Sum | $14.90 | $7.98 |
In this case, the intrinsic value drops to $7.98 from $8.07. Only a small decline in the stock price is warranted if the stock was initially trading close to its $8.07 intrinsic value since the decline in intrinsic value is only minimal.
Delaying cash flows to the shareholder
Expectations can also change about the timing of cash flows paid to shareholders. This will also impact the intrinsic value of a stock.
For the same company above, instead of dividends per share declining, the dividends are paid out one year later than expected. The table below shows the new expected dividend schedule and the present value of the cash flows.
| Year | Dividend | Net present value |
| Now | $0.00 | $0.00 |
| Year 1 | $0.00 | $0.00 |
| Year 2 | $1.00 | $0.83 |
| Year 3 | $1.00 | $0.75 |
| Year 4 | $1.00 | $0.68 |
| Year 5 | $1.00 | $0.62 |
| Year 6 | $1.00 | $0.56 |
| Year 7 | $1.00 | $0.51 |
| Year 8 | $1.00 | $0.47 |
| Year 9 | $1.00 | $0.42 |
| Year 10 | $1.00 | $0.39 |
| Year 11 | $6.00 | $2.10 |
| Sum | $15.00 | $5.24 |
As you can see this has a bigger impact on intrinsic value. The intrinsic value of the stock drops to $5.24 from $8.07. But this is a pretty extreme example. We have delayed all future cash flows by one year. In most cases, our expectations may not change so drastically. For instance, Year 1’s dividend may just be pushed to Year 2. The table below illustrates this new scenario.
| Year | Dividend | Net present value |
| Now | $0.00 | $0.00 |
| Year 1 | $0.00 | $0.00 |
| Year 2 | $2.00 | $1.65 |
| Year 3 | $1.00 | $0.75 |
| Year 4 | $1.00 | $0.68 |
| Year 5 | $1.00 | $0.62 |
| Year 6 | $1.00 | $0.56 |
| Year 7 | $1.00 | $0.51 |
| Year 8 | $1.00 | $0.47 |
| Year 9 | $1.00 | $0.42 |
| Year 10 | $6.00 | $2.31 |
| Sum | $15.00 | $7.99 |
In this case, the intrinsic value only drops by a few cents to $7.99.
Conclusion
A change in expectations for a company has an impact on intrinsic value. But unless the expectations have changed dramatically, the change in intrinsic value is usually small.
Fluctuations in stock prices are more often than not overreactions to new information that the market is prone to make. Most of the time, the new information does not change the expectations of a company drastically and the stock price movements can be considered unjustified. This is the case if the stock price is trading close to its original intrinsic value to begin with.
But bear in mind, this works both ways. Stock price pops can also be considered unjustified depending on the situation. As investors, we can use any mispricing of stocks to earn a good long-term return.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.
