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How to estimate fair value of a stock

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Many finance bloggers like to quote Warren Buffett’s saying “price is what you pay; value is what you get”. However, knowing this is one thing, practicing it is another matter altogether which requires some level of deep analysis. The fact is that you can’t determine the intrinsic value of a company just by staring at the figures stated in the quarterly or annual financial statements. According to MorningStar’s “Why Moats Matter”, there are generally two approaches when it comes to valuation concepts.

How do investors identify great companies? One of the simple tools to value company is through using earnings yield, or more commonly known in the investment community as Price/Earning (P/E) ratio. This simple method requires only current share price divided by the last 12 month’s earning. Companies with high P/E ratio are considered growth stocks.

There are pros and cons in using P/E ratio to measure the value of a company. Whilst this metric is relatively easy to calculate, this approach might not be appropriate for companies whose profits swing significantly from year to year. This is especially for for high growth stocks and cyclical companies like the airlines and IT companies.

Another approach of measuring the intrinsic value of a company is to determine the discounted cash-flow, or DCF. To do that, we need to establish that the Return on Invested Capital (ROIC) exceeds the Weighted Average Cost of Capital (WACC). This is because the fundamental aim of investing is to generate returns that exceed the cost of capital required. To derive ROIC, we need to divide Earning before Interest (EBI) by Invested Capital (IC): EBI/IC.

Next, we need to determine the WACC. From investopedia, the formula for calculating WACC is as follows:

Weighted Average Cost Of Capital (WACC)

  • Re = cost of equity
  • Rd = cost of debt
  • E = market value of the firm’s equity
  • D = market value of the firm’s debt
  • V = E + D
  • E/V = percentage of financing that is equity
  • D/V = percentage of financing that is debt
  • Tc = corporate tax rate

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Updated: February 17, 2015 — 2:38 pm

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