What Is The Fair Value of Stock?

What Is Fair Value of Stocks?

Fair value refers to the intrinsic value of an asset. As such, you can use the concept of fair value for any asset, such as stocks, real estate or currency. Let us try to understand fair value using a simple example first.

Suppose you want to invest in a new stationery shop. Assume that you know that throughout its rough lifetime of the next 30 years, the shop will bring in a total of ₹2 crores, including its resale value. Now you would not want to make an investment of more than ₹2 crores in setting up this shop, because then the profit would be negative, right? Moreover, a large part of the ₹2 crores will come at a very later stage. Thus, the investment today should be much less than ₹2 crores. Therefore, in this context, the value which you should be willing to invest today in that shop is the fair value of that shop.

Similarly, in the case of a stock, the fair value is the price at which the company’s shares should be trading, given all the information about the future gains and earnings of the stock are available to the buyers and sellers. 

The fair value of stock helps investors to make more informed decisions about buying or selling shares at the right price. When a stock is trading below its fair value, it may be considered undervalued and potentially a good buying opportunity. Conversely, when a stock is trading above its fair value, it may be overvalued, indicating that it could be a good time to consider selling. This type of investment strategy based on the fair value of the stock is known as value investing.

Calculating Fair Value

You can calculate the fair value of the stock by various methods such as the Dividend Discount Model (DDM), Discounted Cash Flow (DCF) and Comparable Companies analysis. However, we will discuss DCF in brief below:

Understand Discounted Cash Flow

The DCF model is a powerful tool based on the concept of the time value of money that helps estimate the fair value of a stock. It discounts the potential future cash flows of the company to find their present value. It then uses that present value to find the stock’s fair value today.

However, it is important to note that DCF calculations can be sensitive to the inputs used, such as cash flow projections and the discount rate. Small changes in these inputs can result in significant variations in the calculated fair value. Therefore, it’s essential for investors to conduct thorough research and exercise prudence when using the DCF model.

Fair Value Formula in DCF

You need to apply the following steps to calculate the fair value of the enterprise.

Step 1: Find the present value of the future cash flows of the next few years.

The formula for present value using DCF =  Σ [CFt / (1 + r)^t]

Where:

Σ represents the sum of all future cash flows.

CFt represents the cash flow expected in a specific year (t).

r is the discount rate used to account for the time value of money.

t represents the year for which the cash flow is being calculated.

Step 2: Find the terminal value of the enterprise. The terminal value represents the combined value of all the expected future cash flows beyond the usual period of forecast. The usual period of forecast typically ranges between 3 to 5 years.

The formula for terminal value = {CFt*(1 + terminal growth rate)}/(discount rate – terminal growth rate)

Here, the terminal growth rate is the rough rate at which the company is expected to grow forever. Once you have found the terminal value, apply the present value formula once again, this time on the terminal value. This will tell you how much value does that terminal value have today.

Step 3: Add them up. The final value is the value of the enterprise. However, you need to subtract the value of debt from the enterprise value to find the equity value.

The discount rate (r) is a critical component of the DCF model. It represents the required rate of return. The number that you choose as your discount rate is typically based on factors like the risk associated with the investment and the prevailing interest rates. The higher the risk or the higher the required return, the lower the fair value of the stock. 

The rate also depends on whether you choose the Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE) method to count your cash flows. FCFF is often discounted by the weighted average cost of capital (WACC), while FCFE is discounted by the cost of equity.

Example of Fair Value

Let’s consider a simplified example to illustrate how the fair value of a stock can be calculated using the DCF model. Suppose you are analysing the company ABC, and you expect the company to generate the following cash flows over the next 5 years:

Year 1: ₹1,000

Year 2: ₹1,200

Year 3: ₹1,400

Year 4: ₹1,600

Year 5: ₹1,800

Step 1: Assuming a discount rate (r) of 10%, you can calculate the present value of Company ABC’s stock as follows:

Fair Value = ₹1,000 / (1 + 0.10)^1 + ₹1,200 / (1 + 0.10)^2 + ₹1,400 / (1 + 0.10)^3 + ₹1,600 / (1 + 0.10)^4 + ₹1,800 / (1 + 0.10)^5

= ₹1,000 / 1.10 + ₹1,200 / 1.21 + ₹1,400 / 1.331 + ₹1,600 / 1.4641 + ₹1,800 / 1.61051

= ₹909.09 + ₹991.74 + ₹1,052.18 + ₹1,092.17 + ₹1,116.59 = ₹5,161.77

Step 2: Assume:

Terminal growth rate = 6%

Therefore, the terminal value = ₹5,161.77*(1+6%)}/(10% – 6%) = ₹5,161.77*26.5 = ₹1,36,786.90

Therefore, the present value of the terminal value = ₹84,933.90

Step 3: Therefore, the final value of the enterprise is = ₹5,161.77+₹84,933.90 = ₹90,100.67.

Fair Value vs Carrying Value

While fair value represents the theoretical or intrinsic worth of a stock, carrying value, often referred to as book value, is the value at which an asset is recorded on a company’s books or balance sheet. The carrying value is determined based on historical costs, adjusted for depreciation, amortisation, and impairments.

The formula for the carrying value of an asset = Cost of the asset – Depreciation and amortisation

Fair Value vs Market Value

Fair value and market value are related but distinct concepts. Market value is the actual price at which a stock is trading in the open market. It is determined by the forces of supply and demand, as well as investor sentiment and market dynamics. Market value can fluctuate frequently and may not always align with a stock’s fair value.

Fair value, on the other hand, is an estimate of what the stock should be worth based on fundamental analysis, such as discounted cash flow projections. It represents an intrinsic value that may not necessarily match the current market price. Investors often seek opportunities where the market value is significantly below the calculated fair value, as this can indicate potential undervaluation.

Also Read More About Book Value vs Market Value

Advantages of Fair Value Accounting

Fair value accounting offers several advantages to investors, analysts, and companies:

a. Transparency: Fair value accounting provides a more transparent view of a company’s financial health by reflecting current market conditions and economic realities rather than market movements based on unclear reasons.

b.Risk Assessment: Fair value accounting allows investors to better assess the risks associated with their investments by incorporating discount rates into the valuation process.

c. Adaptability – The fair value method can be used to calculate the fair value of not only stocks but various types of assets like houses or bonds.

d. Useful in both bear/bull markets – At a time when all stocks are falling or rising in price due to major market-wide movements, knowing the intrinsic value will help you temper your emotions and take a more balanced approach. 

Factors Affecting Fair Value

The fair value of a stock can be influenced by various factors, including

1. Earnings and growth – Higher the earnings and cash flow growth of the company, the higher will be its fair value.
2. Market Sentiment – Investor sentiment and market conditions can cause fluctuations in a stock’s market value, which may or may not align with its fair value. 
3. Economic conditions – This includes interest rates, regulatory environments, technological advances and global events that can influence the future earnings and risks of the company.
4. Risk – A higher level of risk due to volatility in prices or earnings, high debt or low cash in the company may require you to adjust your discount rates and thus lower your fair value of the stock.

Final Words

If you enjoyed learning about fair value, perhaps you would enjoy learning more about the stock market from the various articles available on our website. If you want to start investing, open a free Demat account with Angel One today!

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