What Is The Fair Value Of A Stock, And How To Calculate It?

Have you ever been confused about buying something because its price does not match the benefit it offers to you? You might have felt that your favourite shoes, t-shirt, gaming console, etc., are priced higher than they should be. Or, you can say your favourite thing does not have a fair price. A similar situation may also occur when you purchase a stock.

Explore this article to understand the concept of fair value in the stock market. This article highlights what is the fair value of a stock, whether fair value and market value are the same, and various methods and fair value of share formulas that help you arrive at the fair value of a stock.

What Is The Fair Value Of A Stock?

As the name implies, fair value means an asset’s reasonable or appropriate value. 

For stocks, fair value is the value you attach to the company’s stock, considering its financial statements, current market position, and future growth prospects. The fair value principle is subjective. 

Are Fair Value And Market Value Of The Stock Same?

The market value means the price at which the stock is currently trading. The stock may or may not have the same fair and market value. For instance, the stock may have a fair and market value of ₹150, or it may have a fair value of ₹130 and market value of  ₹150, or it may have a fair value of ₹150 and market value of ₹130. 

Here are the differences between fair value and market value.

• Fair value is the value you decide after considering the fundamental factors of a stock. In contrast, the market forces, i.e., the asset’s demand and supply, determine the asset’s market value. 

• The fair value of an asset does not fluctuate frequently. On the other hand, the market value frequently fluctuates due to changes in demand and supply factors. 

• You and your friend may also arrive at different fair values for a stock. However, the market value of a stock is the same for both of you and all other investors. 

Also Read: What Factors Determine Stock Prices?

How To Calculate Fair Value Of A Stock?

You can use various methods to arrive at the stock’s fair value. Some techniques can help you find absolute fair value (value of stock using fundamentals), while others can help you find relative fair value (value by comparing stocks).

Here are various methods to determine the stock’s fair value.

1. Dividend Discount Model (DDM)

You can use the dividend discount model to determine the fair value of a stock that pays dividends. According to this method, the stock’s fair value equals the present value of the stock’s future dividend payments. The model assumes that the actual cash flows investors receive are in terms of dividends.

There are various variations of this model. Here is the stock fair value formula according to the Gordon Growth Model (GGM).

Stock fair value = D1 / (r-g)

Where D1 = next year’s dividend per share

                     r = rate of return

                     g = the constant growth rate of dividend for an infinite period

For instance, You want to purchase a stock of ABC Ltd., which is expected to pay a dividend of ₹30 next year. Historically, the company’s dividend has grown by 3% yearly, and your expected rate of return is 12%. Here is how you can calculate its fair value.

Stock fair value = ₹30 / (0.12 – 0.03)

                   = ₹333.33

It means the fair value of ABC Ltd. stock is ₹333.33. If the stock is trading at ₹400, you may consider it an overvalued stock. In contrast, if the stock is currently trading at ₹300, you may find it an attractive opportunity.

Note: This formula assumes that stocks consistently pay dividends at a constant growth rate. 

2. Discounted Cash Flow (DCF) Model

Various companies may not pay dividends in a regular pattern. For such companies, and even for dividend-paying companies, you can use discounted cash flow methods to arrive at a fair value of a stock.

According to this method, a stock’s fair value equals the present value of expected future cash flows. The discounted cash flow model better works for companies with positive and predictable free cash flows. Free cash flow means the cash remaining after subtracting the company’s operating expenses and capital expenditures.

Here is the formula for calculating discounted cash flow.

Present value = [CF1 / (1+k)] + [CF2 / (1+k)²] + … [TCF / (k-g)] / (1+k)^n-1]

(Source : https://www.thebalance.com/how-to-use-the-discounted-cash-flow-model-to-value-stock-4172618 )

Where CF = Cash flow in the respective period

 k = discount rate / required rate of return (WACC)

 TCF= terminal cash flow or expected cash flow

  n = the period number 

For instance, you want to invest in XYZ Ltd. However, before investing, you want to calculate its discounted cash flow. The discount rate is 10%, and the cash flow growth rate each year is 4%. For simplicity, assume that the terminal value is four times the discounted cash flow of the fifth year.

Here is the company’s expected future cash flow for five years.

Here is how you can calculate a company’s discounted cash flow.

Terminal value = 4(₹1,81,597.75) = ₹7,26,391

Discounted terminal value cash flow = [[TCF / (k-g)] / (1+k)^n-1]

                                                           = [[₹7,26,391/(0.1-0.04)] / (1+0.1)⁴] = ₹8,26,891.38

When you sum up all the figures for all years and the terminal value, you arrive at the discounted cash flow of ₹18,45,838 approximately. 

The number of outstanding shares of XYZ Ltd. is 1,00,000. It means the fair value of a stock is ₹18.45 (₹18,45,838/1,00,000 outstanding shares). Though, XYZ Ltd. is trading at ₹40/share. From the calculation, you can conclude that the stock is overvalued.

3. Comparable companies analysis

The comparable companies analysis is a quick method to arrive at a fair value of the stock by comparing various ratios of different stocks, such as price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, price-to-sales (P/S) ratio, and so on.

For instance, you want to invest in ABC Ltd., which is from the Pharmaceutical industry. However, you want to check whether it is trading at its fair value or higher or lower price than fair value. Therefore, you decide to compare two metrics – the price-to-earnings (P/E) ratio and price-to-book (P/B) ratio of ABC Ltd., with three other companies in the Pharmaceutical industry.

Suppose you find that ABC Ltd. has a higher price-to-earnings (P/E) ratio and price-to-book (P/B) ratio than other companies. In that case, it may mean that the company is overvalued, so you may need to rethink investing.

Final Thoughts

For long-term investors, investing in a fundamentally strong stock is essential to assure long-term wealth. Fundamental analysis aims at arriving at the stock’s fair value, and its comparison with market value helps you make a more informed decision. You can choose a suitable valuation method based on stock type and time.

We, at WealthDesk, enable you to invest in WealthBaskets, which are the combinations of equities and ETFs that reflect an idea, theme, or strategy. SEBI registered professionals manage these ‘WealthBaskets’.

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