How is Fair Value Determined?
One of the most important investment principles is to buy great companies at a good price. Finding great businesses is the easy part, but how do you know if its stock is overvalued or undervalued? The Roen Financial Report calculates “Fair Value” for each of the +/- 250 companies it tracks so that you can know if a stock is cheap or expensive.
Fair value is a measure of where a stock’s current trading price is in relation to what we believe a fair price is for that stock. If a stock looks cheap, a fair value meter for that company will show it as undervalued on its Company Profile page. Conversely if a stock looks expensive, the fair value meter will warn readers with an overvalued signal. (to see a sample company profile click here).
What is the best way to determine fair value? It is a question many analysts ask, and different forecasters use different methods. Some favor looking at what a company has done in the recent past, so they look at “trailing” earnings. Others are more interested in determining a company’s projected earnings for the next few quarters or years, so they use “forward” earnings. Here at the Roen Financial Report we prefer to use a balance of forward, trailing, and current earnings as expressed in a company’s price to earnings ratio (P/E) and earnings per share (EPS) to get the truest picture of what a company’s fair value should be.
For example, Power Integrations (POWI) has performed well since it was entered into the Paradigm Portfolio in May 2009. At the end of March 2012, however, it still looked like a good value. The math below explains why this was so for POWI.
When you average a combination of the EPS at that time, three years of trailing EPS and three years of projected EPS, it comes out to 1.44. The bottom of the fair price range was determined by taking the median of annual P/E lows for the past three years (20.48), and multiplying it by the average EPS determined above (1.44) to get a low fair price of 29.49. The top of the fair price range was similarly calculated by using the median of annual PE highs for the past three years (37.17) multiplied by the average EPS (1.44) to get a high fair price range of 53.52.
The stock price at that time, 37.12, was shown as a percentage of where it fell in the fair price range. This value was categorized in the following manner:
80-100% of fair price range or over top fair price = Overvalued
60-80% of fair price range = Above fair value
40-60% of fair price range = Fair value
20-40% of fair price range = Below fair value
0-20% of fair price range or below bottom fair price = Undervalued