Calculating Fair Value of Stock

The McNiven approach to choosing the right stock!

Calculating fair value using straight forward arithmetic is a critical aspect of value investing. It is an approach advocated by Brian McNiven in his book Market Wise.

The book encapsulates what stock value investing is all about. And that is being able to find the fair value of a stock so that by buying a stock for less than its fair value, a margin of safety can be achieved.

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

Calculating the Fair Value

The arithmetic McNiven uses for the calculation is straight forward, but you need to become familiar with the expressions contained within it. These are explained below the equation.

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 normalized 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 12-16%. The riskier the stock, the greater the required rate of return.

D(%) The percentage of the NROE paid out as dividends.

RI(%) = APC - D, the percentage of undistributed (re-invested) earnings.

Clarifying the Formula

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

D = APC, and RI = 0%.

Stock Value then 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.

McNiven defines the normalized return on equity (NROE) as the normalized 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.

Normalized earnings are defined by McNiven 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 judgment 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 (if they apply in your country) are considered to have greater value.

McNiven applies a 10/7 factor to fully franked dividends to account for this assuming the rate of company tax is 30%.

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

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

The Importance of the McNiven Approach

From a value investing point of view, McNiven's approach to calculating fair value provides a clearer picture of what is important to take into account in company financial statements.

It has also clarifies the relative importance of financial ratios, with (normalized) return on equity being preeminent.

McNiven's methodology outlined in his book reveals a simple message regarding stock valuation that Warren Buffett appears to have known all along.

Quoting McNiven ...

"Because a stock is only worth more than its equity per share when its normalized ROE over the review period exceeds the adopted required return (RR), the identification and therefore avoidance of companies selling above their value is simple"

This equates to a comment attributed to Warren Buffett that a company should over time earn at least a dollar in extra value for each dollar of retained earnings.

To Conclude

McNiven's approach requires the use of historical data that is available on online broker's websites. It also allows the inclusion of forecasted data.

Rather than doing the calculations by hand, I find it easier to subscribe to an investment company that follows McNiven's approach. They provide a calculator for calculating fair value (providing you have subscribed).

The calculator can carry out the determination of the fair value of each stock over the full range of stocks on the stock market.

In that way, I can easily undertake comparisons of the actual stock price to the calculated fair value price to see which stocks provide a good margin of safety.

Stocks that offer a good margin of safety can then be further scrutinized to look into other aspects of their operation.

There are important value investing lessons in Brian McNiven's book Market Wise relating to calculating fair value of a stock.

The related article below examines the importance of other measures.

Related Article

Stock Valuations - discusses a number of other valuation methodologies that are used with a varying degree of complexity to measure stock fair value.

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