In How to buy stocks and cut your risks, we explained the logic of knowing a stock's intrinsic value. We received a mail from a reader who was confused as to whether it was a buy or sell at that price. A stock’s fair value is synonymous with its intrinsic value but cannot be conflated with the “target price” that various sell side analysts and brokerages recommend in their research reports.
The Morningstar fair value is based on how much we believe the stock is worth. This fair value estimate, or FVE, is not meant to be an automatic buy or sell indicator.
To determine reasonable buy and sell prices, we look at a stock's margin of safety. We like to buy when a stock's FVE 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 FVE is too optimistic. On the other hand, when the market price has climbed far above the FVE, this may be an indication that the stock is overvalued and potentially vulnerable to any hiccups that might come along.
How we arrive at FVE
The concept of fair value is the cornerstone of fundamental analysis. To a fundamental analyst, the market price of a stock tends to move towards this value.
To derive the FVE, we use our proprietary 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.
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 FVE.
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.
- Morningstar's approach emphasizes 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.
- Longer time frame for FVE
Analysts typically have a longer time frame in mind when thinking about a company's prospects and how much profit it can generate--sometimes 10, 15, or even 20 years into the future. As a result, we are not particularly concerned with earnings in the next few quarters. On the other hand, target prices from the sell-side analysts most often apply to a six- 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.
- 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.
FVEs 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.
Over the long term, the market is like a weighing machine--assessing the substance of the company. Target prices are geared more toward the former, while FVEs are oriented toward the latter.
