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.
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.
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 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.
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.