A lot of discussions have been devoted to finding the fair value of an investment. The goal of every investor is to find an undervalued investment and sell it when it reaches fair value. Admittedly, this is the hardest part of investing. So, what is fair value? Fair value is a point where the price of investment reflects its earning power
Fair value is relative, and it depends on other factors beyond the investors’ control. Here, we will discuss calculating fair value within our boundary of control. In short, calculating the fair value of an investment depends on the rate of return expected and the risk taken to achieve that return. Higher risk needs a higher reward. It is quite simple
So, what assets constitute lower-risk investments? We can only compare. The first thing that comes out of my mind is the Certificate of Deposit (CD). You are guaranteed a certain return (interest rate) if you can hold for a certain pre-determined time frame. You would never lose your principal at the end of the time frame
The next low-risk investment is Treasury Bond. This is the bond issued by the United States government, which is deemed to be safest in the world. There are certain risks associated with the small fluctuation in the bond price. However, if you held the bond until maturity, you are guaranteed a certain rate of return. Your rate of return depends to a certain extent on the price that you bought the bond at
The next higher-risk investment is buying common stock. This is what we are going to focus more on here. It is considered a higher risk than the two types of investments mentioned previously because you have a higher chance of losing money on your investments. Earlier, we established that higher risk needs a higher reward. Therefore, stock investing requires a higher reward
So, what does this have anything to do with fair value? Quite simply, the price of a common stock that we buy must give us a higher annual return than bonds or CD. For example, if a CD gives you a 3% return, treasury bonds give you a 4% return, then you would want your stock to give you a higher return of perhaps 6%
What does it mean for a stock to give the investor a return of 6%? It never really say it, doesn’t it? You are partly right. While it is not explicitly shown, you can do a little digging and find out how much the return of your stock investment would be. For example, if your Certificate of Deposit (CD) gives you a 2% annual return, for $100 of investment, you would earn $2 every year. Let’s assume that you want your stock to give you a return of 6%, which is higher than CD or treasury bond. This implies for every $100 invested in common stock, it needs to give us a return of $6 annually
Where can we get this information? You can get it on Yahoo! Finance or other financial publications. All we need to do is find the share price of common stock and the profit per share (also known as earning per share) of that particular stock. Let’s use an example to illustrate my point. Magna International Inc. (MGA) is expected to post a profit of $6.95 per share for the fiscal year 2005. Recently, the share is trading at $73.00 and the annual return of buying Magna stock is, therefore, $6.95 divided by its share price of $73.00 and this gives us a return of 9.5%
Will Magna continue to give investors a 9.5 % return year after year? It depends. If the stock price rises, Magna will return less than 9.5 % annually. What else? Well, Magna might not constantly produce the same amount of profit year after year. It might even produce a loss! So, you see, stock investing is inherently risky because there are two moving parts in the equation. Price of the common stock and the profits produced by the company itself. That is the reason why investors need to aim for higher returns when choosing their stock investment
All right. So, let’s move on to the crucial thing in investing in common stock. What is the fair value of Magna stock assuming a constant profit of $6.95 per share? I assign the fair value of a common stock to be at least 2% above the rate of a Treasury bond. Please note that I am using the 10-year bond here. Recently, treasury bonds can give us a 4 % return. Therefore, the fair value of Magna common stock is when it can give me a return of 6%
So, what is the fair value of Magna common stock in this case? For a profit of $6.95 per share, the fair value of Magna common stock is $115.80 per share. That’s right, at $115.80 per share, Magna common stock will return investors 6% annually. Having said that, we should never buy common stock at fair value. Why? Because our investing purpose is to make money. If we buy stocks at fair value, then when do we profit from them? Do we expect to sell it when it is overvalued? Sure, it would be nice if we can do that all the time. But to be conservative, let’s not bank on our stocks reaching an overvalued level
There you go. I have explained how to calculate fair value in common stock. Of course, the $6.95 per-share profit figure is the expectation of profit compiled by Yahoo! Finance. It is not in any way an endorsement to buy Magna common stock. You should do your calculation to verify that number
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