Fair Value
What is a Fair Value?
The Fair Value (also named Instrinsic Value) of a stock represents the estimated worth of a security or company based on intrinsic measures like cash flow, revenue, and expected growth. It is the amount that a buyer should be willing to pay for a security if all the relevant, intrinsic factors were taken into account. It differs from the current market price of the security, which are affected by the boom-bust cycles in the stock market. Fair Value represents an objective assessment of a security or company based on its fundamentals.
To estimate a Fair Value, we avoid the assumption of future growth or potential changes in demand. Instead, we use current, past, and expected performance of both the company and its industry to arrive at a figure for what an investor could expect to receive as capital in the future.
By studying financial statements and analysis of a publicly traded company, investors can either attempt to accurately calculate a fair value or amortize a reasonable industry-related multiple based it. For stocks, this could be a benefit-cost ratio, price to sales, earnings, or cash flow multiple.
Why is Fair Value Important?
The Fair Value allows investors to more accurately assess when buying or selling an asset. When stock prices dip below their Fair Value, it is then that investors will look to buy the stock if they feel the company will outperform in the medium to long term. This helps investors find projects they can be sure represent a reliable value.
It is also beneficial to refer to fair value levels when analyzing positions, as positions bought above the Fair Value will be automatically underwater when investee companies eventually drop in value.
On the selling side, Fair Value can emphasize when selling as buyers are more ardent to bid prices for securities they determine to be overrvalued.
How to Calculate Fair Value?
The most popular method of calculating fair value is the Discounted Cash Flow method. This method uses the future cash flows of a company as well as other macroeconomic factors to arrive at a present value. Other methods to determine Fair Value include relative valuation and historical price-earnings.
Relative valuation compares a choosen Financial Ratio of one stock to the same ratio of another, typically belonging to a company in the same industry. It uses this comparison to help investors see whether a specific stock is over- or underpriced. An example of this would be looking at the price to earnings of one company and seeing if it reaches the same ratio of another company in the same industry.
The third method used is historical price-earnings. This uses historical data of the stock to come up with an intrinsic worth of the stock. It looks at past data and compares it to the current situation to determine whether a stock is over- or underpriced.
Calculating Fair Value of a stock needs to be done by first analyzing the outlook of the company and the industry in which it operates. The company's balance sheet, income statement, and cash flow statement, as well as its book value and earnings per share are also taken into consideration in order to calculate the expected value of the company.
Understanding Fair Value
The Fair Value of a stock provides a better way to assess a stock's true intrinsic value. Knowing this value helps investors to look for value opportunities while avoiding overpriced stocks and investments. Moreover, understanding what the stock's Fair Value is allows an investor to assess the potential gain they might gain after purchasing the stock. Lastly, understanding the Fair Value will also help to better ascertain an investor's risk profile when it comes to investing in the particular security.
Overall, the concept of Fair Value is essential for any investor to make more sound investment decisions. By calculating this figure, investors are better able to identify opportunities which may represent a fair value and make sure that they aren't buying stocks at mispriced levels.
Fair value vs market value
Unlike fair value, market value is the actual price of a stock reflected by investors in the market. It can be affected by external factors such as demand and supply. Market value does not consider intrinsic factors like cash flow and revenue of a company.
For instance, company A maybe has great earnings and cash levels. However, if the market sentiment on the stock is negative and investors are dumping their stocks then the market price of the stock will be lower than its fair value.
Fair value is a reliable method for assessing the intrinsic worth of a stock, given that it takes into account a company's financials and future prospects. It is a more reliable tool when gauging the value of an investment as it is not swayed by external sentiment and factors.
By understanding how to calculate fair value, investors can be sure that they are investing into stocks at a fair price and get great returns over the long term.
“Price is what you pay. Value is what you get.” - Warren Buffet.
In his famous quote, Buffet highlights the importance of assessing whether a company is worth its current Market Value or is it worth more. This helps investors to identify the true value of a company and make more accurate investments.
Fair value and margin of safety
Having an idea of what a company's fair value is helps investors assess the margin of safety of that stock. The margin of safety is the difference between a stock's fair value and its market value. The larger the margin of safety, the better the chance of profiting once the stock moves closer to its fair value.
For example, if a stock has a fair value of $100 and is currently trading at $80 then the margin of safety would be 20%. Alternatively, a stock which is trading at its fair value of $100 would be considered to have a margin of safety of 0%. Generally, investors will be keen to purchase stocks with a wider margin of safety to mitigate risk.