How to calculate the fair value of a stock? Detail Explanation

Investors looking to invest in a company’s stock can find the price of the stock in the stock market. Stock markets such as the New York Stock Exchange (NYSE), London Stock Exchange, NASDAQ etc. all deal in thousands of companies’ stocks.

There are millions of transactions around the world’s stock exchanges every day. An investor can simply buy stock from one of these stock exchanges at the listed prices at that point in time.

However, the prices listed in the stock exchange do no reflect the true value of the stock. Some stocks might be overvalued and some might be undervalued.

It is the investor who must differentiate one from the other. An investor must know how to derive the fair value of a stock, also known as its intrinsic value.

Investors who can master this skill can easily beat the market and stand out from the investors who don’t understand the concept of fair value.

Before understanding the fair value of a stock in detail or how to calculate it, investors should understand a few basic concepts.

Stock

A stock is a security which represents a proportion of ownership in a company. The stockholder is considered the owner of a company for the proportion of stocks of the company they are holding.

The proportion can be determined by dividing the number of stocks held, by the stockholder, by the total outstanding number of shares of a company.

Companies issue stocks in the stock market, as mentioned above, to raise finances for their activities. Investors looking to buy the stock of the company can buy it from the stock market the stocks are listed on.

Importance of Knowing the Fair Valuation of Stocks

In an ideal situation, the fair value of a stock will be equal to its value in the stock market. This would be true for an efficient market. An efficient market is a market in which security prices fully reflect all available information about the stock and any new information about stocks is readily available to the investors.

However, investors should realize that’s not the case. The value of a stock is not related to its stock price on the stock market.

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Investors cannot make informed decisions about the type of stocks they might want to buy and the timing of when to buy and sell stocks without knowing their fair value.

For example, if an investor buys an overvalued stock, they will not make any profit selling it or if an investor buys an underpriced stock but does not sell it in time, they will still make a loss.

By knowing the fair value of a stock, the investor can plan ahead about when to buy and sell stocks of which company.

The Price-to-Earnings Ratio (P/E Ratio)

The P/E ratio is the ratio of the current market price of a stock and its earnings per share (EPS). The P/E ratio tells an investor how much price they are paying for every $1 earned. The P/E ratio is a great tool for investors because it gives them a relative value of the company’s stock.

The P/E ratio method is widely used by investors as a tool to compare stocks of different companies with each other. It can be used to compare stocks of different companies within the same industry or of the same company with its past performance.

Calculating the P/E ratio of a stock is very easy. The price of the share can be easily obtained from the stock market at any time. For earnings per share, an investor must look into the income statement of the company. Companies are required by standards to report their EPS on their income statement. If it is not stated in a company’s income statement, EPS can simply be calculated by taking the company’s profit, after deducting any irredeemable preference shares’ dividends, and dividing it by the number of outstanding shares of the company.

For example, Apple Inc. reported an EPS of $2.58/share at the end of the 2nd quarter of 2020 for 3 months ending March 28, 2020. The EPS for the same period previous year was $2.47/share.

The price per share of Apple Inc. at the end of 2nd quarter of 2020 was $247.74 while for the end 2nd quarter of 2019, it was $174.97. The P/E ratio of Apple Inc. for the 2nd quarter for 2020 comes to $96.02 ($247.74 / $2.58) while for 2019 it comes to $70.84 ($174.97 / $2.47).

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The above information means that for investors had to invest $96.02 for every $1 they earned in the 2nd quarter while they had to pay $70.84 for every $1 earned for the 2nd quarter of 2019.

This means investors had to invest $25.18 ($96.02 – $70.84) more for the same earnings as compared to 2019. This does not necessarily mean the position of the stock has gotten worse.

To understand the above numbers better, investors must know how to properly interpret the P/E ratio. A high P/E ratio can mean that a stock is overvalued.

However, a high P/E ratio may also mean that investors see growth potential or great future prospects for the company and trust investing higher in it. A low P/E ratio can mean that a stock is undervalued. However, it may also mean that investors don’t trust the company has any future earnings potential or the price of the share is not justified.

When it comes to P/E ratios, there are no rules for ideal P/E ratios. Investors must consider other information alongside the P/E ratio to form a decision regarding the stock.

Investors can also use analytical procedures such as comparing the P/E ratio of a stock with the industrial average, the P/E ratios of the company’s competitors, or with historical data of the same company to reach a conclusion.

P/E ratios cannot be used for comparison between companies that operate in different industries, though.

For example, comparing Apple Inc. with Facebook Inc., although both are considered technology companies, will not give accurate results as Apple Inc. is considered a manufacturer while Facebook Inc. mainly deals with social media. This is because different industries have different ways of earning and different demands in the market.

Other Methods

Apart from the P/E ratio, there are many other methods that investors may use to determine the fair value of a stock but are considered complex.

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One other particular useful method of calculating the fair value of stock is using the discounted cashflows method to determine the net present value of any future cashflows from the investment.

This method, however, is more complex as it requires the investors to understand the concept of discounted cashflows or time value of money. In addition, it also requires some assumptions and forecasting to forecast any future cash flows that the investment may generate.

Piling on the idea of future cashflows and time value of money, another method that can be used to calculate the fair value of a stock is the Dividends Discount Model (DDM) and its variants.

This tool assumes that the present value of the stock, or its fair value, is equal to the total sum of all the dividends the investor will receive in the future, discounted to its present value.

Finally, another method widely used by investors to calculate the fair value of a stock is the Residual Income Model (RIM). This model is similar to the DDM, however, instead of discounting the future dividends received from the company, the RIM discounts the future residual incomes of the company to reach a decision.

Residual income is the minimum rate of return of a company subtracted from its earnings for the period.

All these methods consider different information about the company and its stocks.

Therefore, these methods can only be used with data generated or calculated by using the same method. Comparing results from different methods with each other will not produce any meaningful information.

Conclusion

Calculating the fair value of a stock can give investors an edge over the competition and help with making better decisions with their portfolios.

There are many methods that can be used to calculate the fair value of a stock, the most widely used of which is the Price-to-Earnings ratio due to its ease of calculation.

There are other methods that can be used to calculate the fair value of the stock but can be complex and difficult to understand for investors.

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