The fair value estimate is one cornerstone in the Morningstar investment approach, and it can be easily confused with the "target price" that brokerage houses often issue in their research reports.
Most any investment boils down to an initial outlay followed by (hopefully) a stream of future income. The trick is deciding on a fair price to pay for that expected stream of future income.
Let's say a stock trades at Rs 20 per share. If you crunch the numbers--projected sales growth, future profit margins, and so on--you might estimate the stock's fair price per share to be Rs 30. You pay Rs 20 for the stock, and in return you receive a stream of income valued at Rs 30. That's a great deal. If the stock was trading at Rs 40, above the Rs 30 fair value of the future income stream, you are looking at an expensive stock.
Fair value is based on how much we believe the stock is worth, while a target price estimates how much other investors are willing to pay for the stock. Morningstar's fair value estimates aren't meant to be automatic buy or sell indicators. To determine reasonable buy and sell prices, we look at a stock's margin of safety. We like to buy when a stock's fair value estimate is considerably more than its market price. This is important because buying when the stock is trading at a discount protects the investor just in case the fair value estimate is too optimistic.
On the other hand, when the market price has climbed far above the fair value estimate, this may be an indication that the stock is overvalued and potentially vulnerable to any hiccups that might come along.
How we arrive at fair value
To derive the fair value estimates, analysts determine how much they would pay today for all the streams of excess cash generated by the company in the future. They arrive at this by using a discounted cash-flow, or DCF, model. This model assumes that the stock's value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present.
So, the first step is to project how much cash a firm is likely to produce over a number of years, and subtract the amount needed for capital improvements and increases in working capital to keep the business growing. Whatever profits are left over belong to the shareholders. The second step is to discount those profits to understand how much they are worth today.
As with any DCF model, the ending value is highly sensitive to the analyst's projections of future top- and bottom-line growth. In addition, the cost of capital, which is determined by the firm's capital structure and its riskiness, is another influential factor in the fair value estimate.
In contrast, target prices are usually formulated by taking an earnings estimate and then applying a multiple, most typically a price-to-earnings (P/E) ratio. In theory, the P/E ratio shows how much investors are willing to pay for a firm's earnings. For example, let’s assume that Company X’s shares recently traded at Rs 62, compared with earnings over the last 12 months of Rs 1.10 per share. This translates into a P/E of 56. In other words, investors are willing to pay Rs 56 for every Re 1 of the firm's earnings.
To arrive at a target price for the future, sell-side analysts often take their earnings projections and multiply them by a P/E ratio that's appropriate for the industry, or reasonable by the company's historical standards. For instance, let’s further assume that Company X’s consensus earnings estimate for the year is Rs 1.24. If we multiply by the P/E of 56, then we end up with a target price of Rs 69.
There are several key differences worth noting.
The fair value approach emphasises cash flows, while price targets focus on earnings estimates. Both are measures of profitability, and both depend, to a great degree, on the analyst's projections of future performance. However, a company's management often has more discretion over how to report earnings, which can lead to distortions or accounting sleight of hand. Cash flows, on the other hand, are less vulnerable to manipulation.
The time frame also matters. For instance, when thinking about a company's prospects and how much profit it can generate—Morningstar analysts tend to look at 10, 15, or even 20 years into the future. As a result, they will not be overly concerned with earnings in the next few quarters.
On the other hand, target prices from the sell-side analysts most often apply to a 6- to 12-month time period. Because of this shorter window, sell-side models focus on the company's ability to meet short-term forecasts for the next quarter and year.
Keep in mind that what something is worth is not always the same as what someone's willing to pay for it. Just think about the last time you bought a pair of shoes on sale, and felt like you'd found a bargain because you paid less than you felt the shoes were worth. Or, conversely, the last time you went out for a meal and felt it wasn't worth what you'd paid. Our fair values are meant to provide an estimate of what the stock is worth, irrespective of what investors are willing to pay for it.
Fair value estimates are more of a guide than automatic buy or sell prices. As long as you have a good idea of what a stock is worth, you'll be in a better position to determine whether it's a bargain or is overvalued.
