Fair Value

Understanding Fair Value

Fair value is a very interesting term and is used very widely by analysts to determine the right price of an asset. However, depending on the analyst's orientation, its derivation and interpretation can vary greatly.That is why we often see the fair value of one method is drastically different from the other methods, with each being derived or arrived at in a time-tested way.

Two broad schools of thought are represented by two different models of analysis: Technical Analysis & Fundamental Analysis.

Fair Value from a Technical Analysis Perspective

Technical analysts believe in the Efficient Market Hypothesis, i.e., the current market value is the fair value as it factors in all the forces that derive the price at that point in time. That is eventually arrived at by demand and supply. This may include many factors, like company results, macro-economic factors like GDP, inflation, forex rates, political stability, sectoral forecasts, etc.
Some other fine-tuning on this is done by the short-term moving average and overbought/oversold value. We won't delve into them as they would deviate from the subject.

Pros -

The term "fair value" refers to all of the factors that influence the price.
The amount of profit available in an option contract is referred to as its intrinsic value. It determines the value of an asset, a stock, or an investment. The Intrinsic Value shows how much profit exists in an option contract.
It shows whether the stock is trading at its fair value or not. In simple terms, it indicates whether the stock is undervalued or overvalued.

Cons -

Markets tend to move from overbought to oversold levels quite frequently, and analysts often have difficulty finding the right entry point.
Market value is quite efficient when there is a lot of supply and demand for the asset. Generally, F & O and index stocks traded via exchange fall into these categories.

Fair Value from a Fundamental Analysis Perspective

This methodology derives fair value, or more commonly known as intrinsic value, based on the company's financial statement. Fundamental analysts try to find the intrinsic value of companies and select stocks that are trading below their intrinsic value to get undervalued stocks. They use several different methodologies to derive this value, with some of the more common ones being as follows:

1.Book value is calculated by deducting total liabilities from total assets. It considers only the latest year's data. To put this into perspective, analysts need to look at forthcoming expenses, depreciation, cash flow, etc. to rely on this number.

2.Mathematical Model-based - To eliminate the one-off factor affecting the intrinsic value, a lot of models have evolved. In the interest of this topic, we will take a few commonly used ones.

Models of Fair Value

Discounted Cash Flow (DCF)-

A discounted cash flow is one of the intrinsic value methods used to estimate an investment's value based on its forecasted cash flows. It calculates how much returns on investment will generate in the future based on future projections. Looking at DCF analysis before investing in companies, securities, or buying stocks of companies can be helpful to investors. It is also useful for companies or companies' management in making decisions regarding capital budgeting or operating expenditures. When the discounted cash flow is higher than the cost of investment, it is considered a positive. The purpose of this mode of analysis is to help determine how much money an investor would get from an investment.

This model takes into consideration the last five years of data like total revenue, EBITDA, and free cash flow to find its terminal value. It then uses expected GDP growth and other factors (which will be explained in another section) to calculate its fair value. This model is quite popular in many industries, but it's important to note that it does not give great results in financial or banking stocks.

Excess Return Model -

Similar to the Discounted Cashflow model, this model also uses historical data to calculate intrinsic value but uses different sets of parameters like Return on Equity (ROE), Book Value Per Share (BVPS), and Cost of Equity (CAPM).

The Excess Return Model is used for valuing banks, insurance companies, and investment banks. It includes the measures of value using dividends, the undisputed cash flows of all financial companies. The main inputs needed for the excess return model are: the first is the amount of equity already invested in the company; the second is the excess return on equity in the future. And how many other inputs are needed? The main characteristic of this model is that it focuses on excess returns. The financial company that concentrates on its equity and earns a fair-market return on those equity investments will find that its equity market value will converge with the equity capital it has invested in.

This model is more effective for financial stocks compared to the DCF model.

Peter Lynch Fair Value -

Peter Lynch is one of the most successful investors and mutual fund managers in the world. His methods of selecting stocks are unique and simple. He invented his own method to value stocks, which is now known as Peter Lynch Fair Value. It is calculated by multiplying the PEG, the EPS TTM, and the earnings growth rate.This metric shows whether the company is currently trading at its fair value or not.

Graham number -

Benjamin Graham, known as the "Father of Value Investing," invented the Graham number. This value is used to determine the stock's fair value in securities investment. It's calculated by taking the financial figures of earnings per share and book value per share (BVPS). The Graham number represents the highest price a defensive investor should pay for a stock. It is deemed beneficial if the stock price is less than the Graham Number. As per Graham's philosophy, companies can uncover undervalued prospects by thoroughly reviewing their financial statements.

If you are looking for a particular company's fair value or other financial data, you can also go to the Fundamental Overview page.