How do you calculate what you think is fair value for a share?

Sat 9:25am by unbelievablejeff

14 comments 378 reads

I know there is no exact science to this, and but would love to hear different peoples approaches of how you determine fair value of a company. I know this is a broad statement and that you could have multiple ways of doing this depending on the type of company it is and sector it is in etc, but i'd love to learn about the methods of others.

What would be fantastic for me is if you can list the steps you take in your method to calculate.

Are there particular ratios you like to look at?

and whilst the market looks forward, do you place any or much emphasis on historical ratios?

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About the Author

Unbelievablejeff

Premium Member

I've invested for a while but mainly in funds that are multi-asset and that you put your money in and then not do much more! I am now looking to progress and take control of my own investing. As a newbie I have a lot to learn I am sure, but looking forward to it. more »

14 comments

BnB

Sat 9:48am

The father of value investing, Benjamin Graham, ironically proposed a formula for valuing growth stocks. With the additional irony that he intended the formula as a warning about the unpredictability of future growth rates:

V = EPS x (8.5 + 2g), or

Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)

Despite the ironies, this formula has become gospel amongst growth investors and I find it very reliable insofar as whenever my portfolio, which consists uniquely of growth stocks, looks fully valued, then I find that its constituents are right up against the intrinsic value calculator. It’s as though the formula is actually driving the valuation process instead of individual idiosyncrasies of the stocks.

So there’s what I find to be a really helpful baseline for valuation. But, be warned, it won’t work for companies that have gone ex-growth.

WarrantStar

Sat 11:20am

Hi BnB. That's very interesting. Please can you define g? Is it percentage change in revenue or reported or normalised EPS? Are all the figures used the latest historic ones?

WarrantStar

Sat 11:33am

I have a spreadsheet to calculate the expected share price 12 months ahead. It always calculates the SP 12m ahead no matter what the current stage of the year is. It is based upon the formula Share price = Normalised EPS x PE ratio. So firstly I have to come up with a figure for Normalised EPS 12m ahead, then I have to come up with a figure for PE ratio 12m ahead. I mostly use it with growth companies, and it has served me well. There are a couple of drawbacks 1) It takes some time to do it properly. 2) It tends to rely on forecasts which are often inaccurate.

Alphaflight

Sat 11:52am

A company's stock prices is meant to reflect the "present value" of the company's expected future cash flows (which are of course unknown in reality). Based on this you can price a company's shares at a fair value. If you buy a typical undergraduate finance degree book you'll find various chapters dedicated to the time value of money (present value etc)...

BnB

Sat 12:17pm

“g” is the annual rate of earnings growth. This is often taken to be from Year 0 to Year 1. But, for mature growth companies, I use a 5 your 10 year average. And for fast growing young companies, where the growth rate is high but falling, I use a blend of the next 3 years forecasts. Because it’s relied upon by so many investors, it’s a good tool for anticipating market behaviour.

WarrantStar

Sat 12:25pm

BnB. Thank you. And do you use reported or normalised EPS? or do you review the adjustments and decide which you accept and which you reject?

N0vice1Nvest0r

Sat 12:41pm

It's well worth reading/listening to 'The Intelligent Investor" by Benjamin Graham for further insight.

My investment style is more overall. In my personal opinion cash is king! This is not definitive and i'm still learning as i'm still a novice. I like the naked trader's style and Michael Burry.

I look for high levels of cash mixed with low levels of debt (preferably negative net debt). With this I then look for continued growth with good profit/net profit. Look into the stock and find what it does. Jet2 (LON:JET2) is a great stock in my opinion. HOWEVER included in my style is looking for fair value and I do this by looking at the Technical analysis chart on a daily timeframe, and even weekly.

With this I see whether it is high or on a dip. I then look at the chart and try to find good areas to buy at. These don't always hit, but ive found and prefer to wait for a stock to hit the price I want, rather than chasing that price.

So for me a fair price is a stock that is reading low on a chart and still looks good fundamentally as well as on a balance sheet.

So say with Jet2 (LON:JET2) (as an example) it has excellent growth, profit, cash and not too much debt to turnover. Comparing it to its chart it is slightly high but could be consolidating at this price. Personally I think it drops a little further down eventually so would wait for this stock or Dollar cost average in.

Like I say I'm a novice and still learning, this method isn't perfect, but it can find some excellent stocks. It's important to understand the market of what you're purchasing and also to keep an ear out for fundamentals that could change the outlook for a company/stock.

Hope this helps.

You should definitely come up with your own preferred trading/investment strategy and then it just becomes a tick list and so much quicker.

BnB

Sat 1:04pm

I don’t rely very heavily on the formula when valuing individual stocks, since over- and under-valuation is also evident in analyst notes, the chart technicals, PER relative to history etc. It’s usually pretty obvious when a name is undervalued . And, it’s extremely rare for me to sell when a stock becomes overvalued. I just find the formula very helpful for assessing the state of the overall market. But it definitely works in respect of individual names where I would accept the adjusted numbers, but with caution if there is a big discrepancy from the reported.

Anton Crabbe

Sat 1:55pm

Look at the asset value/book value and how much cash flow they produce and then look at their share price.
Do this for a few large blue chip stocks. Mid sized stocks and small cap. And across a few different sectors too.
Eventually you will see what stocks have value and what don’t, and what you should pay for them.

WarrantStar

Sat 3:13pm

I just asked Chatgpt about this formula and it suggested that for modern markets, it may be more appropriate to modify it to V = EPS x (8.5 +1.5g) or even V = EPS x(7 +g). Obviously the latter is the more drastic modification of the two. Do you have any comment on these possible formula revisions please?

BnB

Sat 3:44pm

The only comment is that these are more prudent. But you would never end up owning any of the world’s greatest companies if you waited for them to look undervalued by those revised formulae. Absent a major market crash, of course. But you don’t need the formula then because EVERYTHING will be undervalued.

Personally, I don’t believe in looking for value. I believe in looking for outstanding companies who will compound your investment for decades.

WarrantStar

Sat 8:10pm

Markets will always be forward looking. On stockopedia the Value rank is entirely backward looking, and in my opinion, of no use at all whatsoever. My preferred value measure is 12m rolling forward price earnings ratio.

unbelievablejeff

Sun 5:14am

Thanks everyone for the replies so far, very useful.

WarrantStar

Sun 10:43am

My final comment on the question is that, after a lot of thought on the subject, I will use the following version of the Graham formula: V = EPS x (8.5 +1.5g). I am mostly looking for growth companies. My primary intention is NOT to look for very under priced but good growth companies because I am unlikely to find any. But my intention is to use the formula to rule out buying the most excessively over priced growth companies.

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How do you calculate what you think is fair value for a share?

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Unbelievablejeff

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