Tuesday, August 9, 2016

How to Find the Fair Price of Stock?



Value Investing is about determining the fair price of stock, comparing the value with the stock price and trying to buy the stock below its intrinsic value when the markets are depressed or not very enthusiastic about that specific stock. So, this is the short answer to the question, "how to find the fair price of stock?"

There are Three Essential Ingredients in Determining the Fair Price of Stock as follows:

  1. Earnings Per Share: Reducing the earnings (net profit) of the company to the level of a single share.
  2. Book Value Per Share: Bringing down the net assets of the company again to the single share.
  3. Current Market Price (CMP) of the Share: This is the price at which the share is presently trading in the stock market.

Three ingredients to determine fair price of stock



Three Golden Ratios to determine Fair Value of Stock

 Therefore, from the above-described three ingredients, we can derive three valuable ratios or proportions for determining the fair value of stocks, as follows: 
  1. Price to Earnings (PE) Ratio: This ratio indicates at how many times the earnings the share is trading in the market. A positive number of up to 15 is reasonable and fair.
  2. Price to Book Value (P2BV) Ratio: This ratio reveals how many times the net assets of the company are trading on the stock exchange. I recommend a P2BV ratio of 1.50. This means that you can pay a maximum of 1.5 times the net assets as the price.
  3. Combined PE*P2BV Ratio: You obtain this ratio by multiplying the PE and P2BV ratios. Benjamin Graham recommends the number below 22.5 (15*1.5). Any positive number below 22.5 is fair.


three golden ratios to determine fair price of stock

Fixing the Fair Price of a Stock:

We have already determined the fair value of the stock. What remains is deciding what price to pay for the stock. It is quite obvious that once we know the value, deciding the price is quite easy; we simply would like to pay the lowest possible below the fair value, if the stock is available or someone is willing to sell at such a price.

What if the market price of the stock is above its fair value?

There are two possible scenarios as follows:
  1. The price of the share is slightly higher than its fair value - the PE Ratio is 16 or the P2BV Ratio is 1.65 - this means the stock is trading at a slight premium
  2. The price of the stock is steeply higher than the intrinsic value - this means the share is expensive.
What investment decisions should we make in the present situation?
Let us examine the following live example of stocks of two companies:

table showing calculation of fair price of stocks, three in number


All the three companies, SJVN and MOIL and Gillette India are excellent companies and worth buying. However as on 14th July 2017,  you can buy SJVN shares at a fair price, MOIL is slightly expensive and Gillette India shares are highly expensive. You can buy SJVN shares without any hesitation, MOIL share with the crib as it is slightly pricey and Gillette India, though is a wonderful company, its shares are highly expensive and should not be bought.

Suggested Further Reading


Conclusion


Valuation of shares is both an art and a science. The answer to the question, "How to Find the Fair Price of Stock?" is closely linked to the share's intrinsic value. You will never find stock prices exactly matching their intrinsic value. But if the price is at par or below or slightly above the inherent value the price is fair.  If the price far exceeds its intrinsic value, the stock is expensive. It is important to buy stocks only at a fair price.

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