Fair Value As A Basis For Investment Decision Making

Reading time ~12 min
Key takeaways:
-How to tell if a company is undervalued or overvalued
-A quantitative approach based on P/E allows you to quickly and easily evaluate a company
-Using the average and maximum value levels as entry and exit points

One of the most common and traditional methods of choosing stocks and moments to buy is value investing. And in this context, fair value is the key. To describe in simple words the process that happens every day in the stock market, it is a dispute between various market participants about how much a company can or should be worth. Some buy, others sell, and someone watches what is happening from the side. Supply and demand ultimately form the only objective value of the company at the moment — the share market price.

However, there is also another value. Buyers and sellers obviously have their reasons for action. Why add a stock to your portfolio? Definitely to benefit from the growth of the company’s price in the future. Those selling the shares have a contrasting view of the company’s prospects. Everyone has in their minds a certain price level that they consider reasonable for this company at a given time. The beauty of investing is that no one is limited in their choice of tools to determine this value. Rather than reviewing different approaches to value investing, we will share insights into the quantitative one we take at Eyestock.

Overvalued companies

You may often come across the term overvalued. It refers to a company whose shares are considered expensive and unprofitable to buy at the current moment. However, it is important to understand that overvaluation, as well as undervaluation, are relative concepts. A comparison of the current price and the fair level makes it possible to operate in these terms. An interesting point is that this level may be different for everyone, but everyone will call it fair. Since these are the rules of the game, you can see the ANET stock fair market value by Eyestock approach on the chart below.

How to perceive information that shares are overvalued? It is too reckless to expect an immediate price fall. A stock can remain overvalued for a long time, that is, trade at a premium to enterprise value for various reasons: primarily due to the influence of various news, political and economic factors on the investor’s expectations. However, this serves as a signal that it is a high-risk investment at the moment, and medium-term and even long-term investors should be very careful about how the stock is currently quoted on the market.

What if stock is undervalued?

Undervaluation is a term for a situation where the market price for some reason is lower than the fair one. In general, this means that there are profitable prospects for such an investment because you can buy an asset at a discount relative to its expected value. Again, don’t expect the price of such a stock to rise immediately. For example, HSY stock is undervalued but has been trading below its fair level for almost a year.

How to determine fair market value

There are many methods for stock valuation and there is not one that is ideal and absolute. But it so happens that many retail investors do not use any of them. Therefore, we will give you a guide on how to calculate fair value using a quantitative analysis method based on the historical price-to-earnings ratio.

The idea behind our approach is very clear. Instead of subjectively assessing the current present value of future earnings, we prefer to analyze the actual valuation of the company as provided by the stock market over the past 3-5 years.

Step 1: Find the P/E ratio meanings for the last 5 years.

You can do the calculations yourself using the ratio formula. You can also divide the company’s capitalization by its net profit — this will not change the result. It is important to note that to avoid seasonal fluctuations, it is correct to use profits for the last 12 months.

Each quarter, following the results of the financial report, we take into account the profit for the last 4 periods and calculate the market valuation of the company. In this way, we will know how many dollars investors were willing to pay for $1 of net income that the business generates to become shareholders of the company. And this research will help us understand what stock price is reasonable to buy in the current period.

Step 2: Find the median meaning.

What is extremely common when analyzing value is further comparison of the resulting P/E ratios of various companies with each other and the industry`s average. This is called relative valuation. How can this help in making a competent, informed decision?

Let’s look at the example of two famous companies from the semiconductor industry: Nvidia and Intel.

Does Intel’s 36 P/E mean that INTC shares are undervalued compared to Nvidia’s 74 P/E? The average industry multiplier ranges from 28 to 122, depending on the source and calculation base. It seems that such an analysis is not entirely correct. Rather than comparing different companies with distinct business characteristics, we prefer to compare a company’s valuation relative to itself historically.

Let’s return to SNA stock, the table of multiplier values ​​for which we showed above. This is an ideal case study of how quantitative analysis works. So, over the last 5 years (or 20 quarters), the maximum that the Market gave in dollars for $1 of net profit was 15.56. The minimum meaning is 12.47, while the average one is 13.75. To calculate the average value, we resort to the median search method to neutralize extreme deviations of the indicator.

Step 3: Get the fair value.

The median value provides practical insight into how the Market evaluates a company’s business over time. And if the normal value for Snap-On is 13.75, then we take it to calculate the fair price level. To do this, you just need to multiply 13.75 by the earnings per share (eps) for the last 12 months. This gives us a potential purchase level of $262.23 per share.

How to use

The median P/E multiplied by 12-month EPS as a normal or fair level can be used as an entry point for long-term investors. When a company’s capitalization rises to the upper extremum level, this can serve as a signal to reduce or completely close a position. If we talk about the minimum P/E, then the price does not appear there very often. As a rule, this happens during periods of crisis in the markets or for a specific company. However, it is an even more profitable way to start investing and is likely to suit the most conservative investors.

In this particular example, a similar investment strategy with position control could have returned 50%, while the company’s capitalization only grew by 20%.

Bottom line

Each approach has its own advantages and disadvantages. The quantitative method based on historical multipliers does not take into account market expectations regarding growth prospects.

Let’s assume that the company has made some kind of breakthrough in technology, and the entire investment community understands that the business has a bright future ahead with much more solid profit growth rates. But even in this case, the quantitative method works well.
Look at NVDA shares: in 2022, it was possible to safely accumulate a position in shares; at the beginning of 2023, before the start of an upward trend, the price again pushed away from the yellow level. And even when the AI ​​boom entered an active phase, the departing Nvidia price train made it possible to board it for $45 or $70.

The undoubted advantages of this approach to cost estimation, in addition to efficiency, are its simplicity and accessibility. Just like any systematic method, it allows you to save time and emotions by making informed and informed decisions every time.

You can use this assessment to add it to your own investment strategy as a way to look for an entry point, but don’t forget that the quality of the business itself is also worth scrutinizing, which we’ll tell you about in another article.