Now that you have obtained reasonable figures for the future earnings, it is time to calculate the present value of those future earnings.
Firstly, you must determine the required rate of return. Consider what would you receive if you had placed the money in a riskfree alternative like government bonds. The returns you get from that alternative investment will be your required rate of return or discount rate.
In our example, we will use a discount rate of 10%. Using the formula for computing present value, we discount each future year's earnings and the resulting figures obtained are given in the following chart.
If we add up all the green bars in the chart above, we would obtain the net present value of XYZ company which is $17.25. This figure gives us a reasonable estimate of the fair value of the company. If XYZ stock is trading at a lower price, it is undervalued and possibly a good time to pickup some shares. Otherwise, it is overvalued and you should consider selling some shares if you own them.
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