Intrinsic Stock Value vs. Book Value

Does an elaborate firm valuation model outperform the blunt instrument of a simple ratio? In their July 2024 paper entitled “Intrinsic Value: A Solution to the Declining Performance of Value Strategies”, Derek Bergen, Francesco Franzoni, Daniel Obrycki and Rafael Resendes model the intrinsic value of a stock, defined as book value of equity plus the discounted sum of estimated future profits with a firm-specific discount rate. Their intrinsic value model includes for each firm:

• A profit forecast based on ultimate decay to zero, with the the path to zero guided by assumptions derived from the historical profit series for the firm, such as:
  • High profits may attract competitors that accelerate decay.
  • Low profits may persist.
  • Stable profits may persist due to a reliable competitive advantage.
  • Volatile profits have rapid decay potential.
  • Large firms have barriers to entry or economies of scale that support profitability.
• A forecast for reinvestment of firm operating cash flow after interest expense, dividends and replacement capital, assuming a consistent capital structure.
• A discount rate estimated by adjusting the median internal rate of return across all firms according to individual firm size and financial leverage.

They apply firm intrinsic value-to-market ratios (IVM) to forecast stock returns, comparing their accuracy to those of the conventional book-to-market ratios (BM). Using monthly inputs as specified for Russell 1000 and Russell 2000 stocks during July 1999 through December 2023, they find that:

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