Calculating Fair Value of Stock
Helps in choosing the right stock!

Calculating fair value using straight forward arithmetic is an approach advocated by Brian McNivan in his book Market Wise.

The fair value of a stock can be considered to be synonymous to the intrinsic value, or true value of a stock.

The equation he uses as a stock fair value calculator can be expressed as:

Stock Value ($) = E X (((APC / RR) X RI) + D) / RR where

• E = Equity per share ($)
• APC(%) is what he calls adopted performance criteria that can be the internal rate of return for the review period (recommended to be five years) or the normalised return on equity (NROE), or some other criteria
• RR(%) is the required rate of return which may vary with the perceived degree of certainty in achieving the APC, but commonly sits around 15%
• D(%) The percentage of the NROE paid out as dividends
• RI(%) = APC - D, the percentage of undistributed (re-invested) earnings

When all earnings are distributed, D = 100% of APC, or in other words D = APC, and RI = 0%.

Stock Value the becomes:

Stock Value($) = E x D / RR = E x APC / RR. When APC = RR, Stock Value = E for RI = 0.

Of course most companies distribute some earnings and the top equation accounts for this.

Effectively what the top formula does is to multiply the equity per share (E) by a multiplier in calculating fair value, taking into account that some earnings are distributed. So, looking further at that formula ...

APC/RR can be simply viewed as the ratio of the assumed rate at which retained earnings are re-invested compared to required return.

If this ratio is greater than one, then this increases the value of RI.

When the ratio is less than one, then the value of RI is reduced.

While the dividends (D) are treated at face value, the increase or decrease in RI will impact on the multiplier of equity per share (E).

Taking the case, for example, where APC = 30%, RR = 15% and RI = 20%, the formula doubles the value of RI since
APC/RR = 30/15 = 2.

The formula ensures that the greater the proportion of retained earnings re-invested at a rate (RI) that exceeds the required return (RR), the more desirable the stock and hence the higher the value.

McNivan defines the Normalised return on equity (NROE) as the normalised earnings divided by the average common equity employed during the financial year, expressed as a percentage.

He regards NROE as a measure of the annual profitability of the business - as distinct from its annual profit.

Normalised earnings are defined by McNivan as "declared profit after tax plus positive changes in reserves, less negative changes in reserves, less abnormal profits and abnormal changes in reserves, plus abnormal losses and abnormal changes in reserves."

He argues rightly that some judgement is required to decide whether abnormal profits and losses and changes in reserves ought to be treated as such, or be treated as normal business income or expenses.

Also, dividends that attract franking credits are considered to have greater value.

McNivan applies a 10/7 factor to fully franked dividends to account for this.

All these potential adjustments to earnings indicate that calculating fair value for a business requires some judgement, as well as some arithmetic.

And it brings to mind Warren Buffett's comment that it is better to be approximately right than precisely wrong.

The beauty of McNivan's approach to calculating fair value for me is that it has provided a clearer picture as to what is important to look for in company financial statements.

It has also clarified the relative importance of financial ratios, with (normalised) return on equity being pre-eminent.

McNivens methodology outlined in his book has revealed a simple message regarding stock valuation that Buffett appears to have known all along. Quoting McNivan ...

There are important lessons for value investors in this book!

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