A lot of discussions have been devoted towards finding fair value of an
investment. The goal of every investors is to find 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 an investment reflect its earning power.
Fair value is relative and it depends on other factors beyond the
investors' control. In here, we will discuss on calculating fair value
within our own boundary of control. In short, calculating fair value of
an investment depends on the rate of return expected and the risk taken
to achieve that return. Higher risk needs higher reward. It is quite
simple.
So, what asset constitute lower risk investments? We can only compare.
First thing that comes out of my mind is Certificate of Deposit (CD).
You are guaranteed 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 certain rate of return. Your rate of return depends to
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 here. It is considered 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 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 gives 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
gives you a higher return of perhaps 6%.
What does it means for a stock to give 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 a 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 fiscal year 2005. Recently, the share is trading at
$ 73.00. The annual return of buying Magna stock is therefore $6.95
divided by its share price $ 73.00. 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
part in the equation. Price of the common stock and the profits
produced by the company itself. That is the reason why investor need to
aim for higher return 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? Personally, I assign fair value of a common
stock to be at least 2% above the rate of Treasury bond. Please note
that I am using the 10 year bond here. Recently, treasury bond 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 a 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 it? 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 overvalued level.
There you go. I have explained how to calculate fair value in a 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 own
calculation to verify that number.
