In the stock market, there are a ton of different ways of defining, calculating, and assessing value.
The market value of a stock is the most simple, as it is just the price the market currently assigns to the asset. Fair value, however, isn’t quite as simple.
Fair value in investing is “the value an individual investor assigns to a company’s marketable securities based on his or her analysis of a company’s financial information.” The derived value is then compared to the market value in order to determine if the stock is over or undervalued.
This means “fair” value is totally up to you and your interpretation of the stock, its financials, market, risks, growth potential and etc. So fair value is up to you based on what kind of investor you are and your preferred valuation method.
Things like dividends, the size and maturity of the company, economic outlook, and its price relative to competitors are all factors that change a company’s “fair” value from person to person.
In finding the fair value of a stock, investors must determine if they are looking for an absolute or relative valuation. This is because the fair value can be either a specific number, derived from a valuation model or represent more of a range.
Absolute
Absolute valuations can be thought of as aiming to be “true” valuations of the company. Absolute valuations focus on the fundamentals of the company. These calculations provide you a specific “fair” value and can be derived through models such as the Dividend Discount Model or the Discounted Cash Flow model.
The Dividend Discount Model calculates the value of the stock by assuming that the price of a company’s stock is equal to the sum of all of its future dividend payments when discounted back to its present value. The DDM uses estimated dividend growth rates and expected dividends per share and, thus, can only be used with companies that pay a regular dividend.
The Discounted Cash Flow model calculates the value of the stock as well but uses revenue growth instead. DCF analysis calculates the present value of expected future cash flows using a discount rate.
For both models, if the current market value of the stock is under the price calculated, then the stock could be considered to be below its fair value.
Relative
Relative valuations are quicker in nature and focus on comparing key ratios between competitors to figure if a stock is undervalued. The most popular ratio, being, the PE ratio.
If a company’s PE ratio is lower than competitors, but its margins and revenue are growing at a similar rate, then an investor might say that the stock is currently undervalued.
You could leave it at that and simply say the stock is below fair value or you could calculate the price at which the stock would need to be in order to have a comparable PE ratio to the industry average or its closest competitors, and then call that the fair value.
Conclusion
In summation, the fair value of a stock is something unique to each investor. Fair value can be quickly derived from relative methods, but can be more complexly - and hopefully accurately - calculated using absolute-value methods such as the DDM and DCF models.
Learning what kind of investor you are can help you decide how to calculate it while comparing a stock's stats with its competitors can help you make quick assumptions about the stock’s current market value.
