How Do I Determine the Fair Value of a Stock?

The fair value of a stock can be calculated using the concept of present value. With this type of calculation, projected income streams from the stock are discounted to what they would be worth at the point of purchase. Savvy investors seek stocks that have a fair value above the current purchase price or an acceptable price earnings ratio. Projected income from a stock is calculated using a company's financial statements, such as the balance sheet, income statement, and statement of cash flows.

The investment's intrinsic value is equivalent to the fair value of a stock. It is the value contained within ownership and is influenced by internal factors, such as a company's dividend payment policy. One way that stock analysts try to determine a stock's fair price is to compare its current market price against what the stock is projected to earn over a specified period of time.

Potential future streams of income that will be received from owning a particular stock can be determined by examining a company's financial statements. Financial analysts attempt to speculate how a company will perform financially by comparing its assets against its liabilities, how it uses cash, and the strength of its market position. The fair value of a stock is calculated per share by taking into account future earnings, which are affected by a company's projected sales growth, market share, and net profit. Once a stock's potential future earnings are determined, the next step is to discount those cash flows to their present value.

Most financial calculators will discount a future cash flow to its present value within seconds. A present value simply takes future earnings and determines what they would be worth today. It is similar to the concept of deflation, where the value is discounted against the rate of return or growth. For example, if an investment earning six percent will produce a future payment of $100 US Dollars (USD) in five years, the present value calculation would discount the $100 USD at six percent for five annual periods.

Some investors and analysts determine the fair value of a stock by its price earnings (PE) ratio. The ratio is simply the stock's market price divided by its projected earnings. An annual earnings growth ratio is compared to the stock's PE ratio, with a good stock having an annual earnings growth ratio equal to or greater than its PE ratio. The fair value of a stock is also compared on a per share basis, with a solid stock's share price equal to or less than its per share earnings projection.