Calculating Stock Fair Value

Calculating stock fair value or stock intrinsic value, has been a long journey for me that has followed a number of paths.

This has been partly caused by the lack of, or conflicting direction provided by the information sources that one normally consults to learn more about this vital financial matter.

Continuing confusion in the financial press between stock price and what constitutes fair value of stock has led to common ratios such as the price/earning ratio and price to book ratio being used as a measure of fair value.

These ratios provide a 'relative' measure of value only, and are useful to make (relative) comparisons between similar companies and with the market as a whole.

However, they do not provide what I call an 'absolute' measure of stock fair value that is based on the ecomomics of the company itself, and not on its current price.

It was no suprise to read the 1985 remark of Warren Buffet that ...

"there has been no trend towards value investing in the 35 years that he has practiced it".

But more suprising was his comment that ...

"there seems to be some perverse human characteristic that likes to make easy things difficult".

This may be very well and good for Warren Buffett who obviously finds value investing a breeze. But for ordinary investors, finding information on calculating stock fair value is not an easy exercise.

It is somewhat dependent on the degree of objectivity or subjectivity you are comfortable with and/or the degree of complexity that may be involved and whether you can handle that complexity as easily as Warren Buffet.

Analysts are commonly employed to carry out the valuation task for brokers, fund managers and investment advisors.

But what the average investor ends up seeing is usually distilled down to buy/reduce/sell/avoid recommendations with zero information as to how the recommendation has come about.

A number of valuation methodologies have been used as a stock value calculator, the most common 'commercial' method in use is the discounted cash flow (DCF) analysis for calculating net present value. It is based on how much money a company is likely to make in the future.

Because money in the future is worth less than it is today, this estimate is 'discounted' to determine the company's worth today.

Dividing the calculated "worth" of the company by the number of shares on issue provides a valuation of the stock that can be compared to the current share price.

Check out this link for a discussion of the discounted cash flow methodology and a discounted cash flow calculator.

A simplified version of the DCF methodology can be achieved by substituting stock dividends for the cash flows and applying a constant growth model to the company's dividends.

In his book, The Intelligent Investor, Ben Graham provides an alternative straight-forward formula for calculating fair value of 'growth' stocks that is intended to produce results similar to those from more refined mathematical calculations such as discounted cash flow (DCF) calculations.

It appears that he may have struggled with the DCF methodology, or some of its assumptions.

Brian McNiven, the author of Market Wise also had difficulty with some of the assumptions of the DCF model. He provides an alternative 'absolute' approach to DCF analysis based mainly on historical company performance over the previous five years - or four years and one projected year.

His approach is based on determining a multiplier to the equity per share using an Adopted Performance Criteria (APC) which in some cases might be the 'normalised' return on equity or the internal rate of return of the cash flows over the period in question.

I am more comfortable with the McNiven approach to calculating stock fair value outlined in the link above as its determination is completely (absolutely) independent of the stock price - as any estimate of stock intrinsic value ought to be.

Why? Because the value of a stock is determined by the economics of the company, whereas the latest stock price is what one buyer agreed to pay to a seller.

Irrespective of the valuation approach taken, I try not to be blinded by numbers. Qualitative considerations play an important part in any final decision as to whether a stock that appears to be (numerically) undervalued is a worthy candidate for my portfolio.

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