5th letter to friends of Brunei [Stock Valuation (part 2)]

As you can see from the previous blog entry, the dividend discounted model method of calculating intrinsic value of a stock has two important variables:

1. k = Required Rate of Return of the stock;
2. g = The (Sustainable) Growth Rate.

Let me explain further:

1. Required Rate of Return (k)

Assuming there is risk free investment product which gives you 2.5% return. If you wish to invest into another stock, obviously you will expect this stock to give you a return above the risk free rate. This expected addition return rate is known as risk premium. Mathematically, this is:

k = Risk free rate + risk premium rate

Risk premium = beta x (historical return of stock in the market - risk free rate)

= beta (Rm - Rf )

Beta is the sensitivity of the stock compared to a stock market index(e.g. STI or S & P 500).

For example: S'pore T-bill has a yield of 2.5%. Assuming RHB bank has a stock beta of 1.4 and has a historical return of 6%, RHB bank's required rate of return is:

k (RHB bank) = R (t-bill) + beta (Rm - Rf) = 2.5% + 1.4 (6%-2.5%) = 7.4%

Incidentally, the formulae for calculating k is also known as the Capital Asset Pricing Model (CAPM), which is an important formulae used in portfolio management.