You have many times heard about a stock being undervalued or stock being overvalued. That sparks curiosity about what is the actual value of a stock.
That actual value is also called the fair value.
Don’t confuse fair value with market value because the market value could be higher or lower depending on various factors such as demand-supply (will discuss later) but the fair value is the value based on the fundamentals of that company.
Let’s discuss further.
What is Fair Value
Before you know the fair value of a stock, you must understand what fair value actually means.
Fair value is the actual value of an asset on which the seller and buyer have agreed to make a deal. Or, a value reasonable to the buyer and without making a loss to the seller is the fair value.
What is Fair Value of Stock
Fair value is a measure to understand whether the stock price is close to its fundamental value neither low (due to a market crash) nor high (because of the market rally).
Stock prices are highly dependent on multiple factors like demand-supply, political news, business decisions, investor sentiments, and so on.
You need to get the fair value or intrinsic value of a stock before you buy it. Intrinsic value helps you understand the stock value beyond its current market price.
Since the stocks can be undervalued or overvalued depending on the above-said factors, the intrinsic value gives clarity if the stock would be profitable (if bought below fair value) or not.
For example, a share’s current market price is Rs.100. When calculated, its intrinsic value is Rs.90. If the stock price falls from Rs.100 to Rs.80 in a few months, now the stock would be trading at Rs. 10 of its intrinsic value.
How to Calculate Fair Value of Stock
You can calculate the fair value or intrinsic value of a stock using the formula given by Benjamin Franklin in “The Intelligent Investor” book and modified to use in the Indian context.
The intrinsic value formula is –
V = EPS x (8.5 +2g) x 8.5/Y
- V = Intrinsic Value.
- EPS = Earning Per Share.
- 8.5 = Assumed fair P/E ratio of Stock.
- g = Assumed future growth rate (7-10 years)
- Y = Interest Rate of AAA Corporate Bonds in India on today
For example, let’s calculate the intrinsic value of the ITC share.
- Current share price – Rs. 200 (approx)
- EPS as per records – Rs. 10.55
- Expected future growth rate – 10%
- Corporate bond interest rate – 7%
The Intrinsic value or fair value of ITC share = 10.55 x (8.5 + 2(10/100)) x 8.5/7 = 111.45
However, you have to understand other factors like the company’s management, debt to equity ratio, PE ratio to know if actually, a stock is valuable or not.
Also read – Bonus share vs Stock split
Benefits of Calculating Fair Value of Stock
- Identify the profitable stocks
- Helps in avoiding overpriced stocks
- Reduces chances of losing money
I have tried to educate you on the simplest method to calculate the fair value of a stock. There are several other methods like the DCF (Discounted cash flow) Method to find the fair value of a stock.
Go with what you feel easy to understand.
Once you start calculating the fair value, you would be able to learn other terms like Price-to-book ratio (P/B ratio), Book value per share (BVPS), and Price to earnings ratio (P/E ratio) for a more in-depth analysis of a stock price before buying.