Buy Wonderful Stocks at Fair Price

Man happy at having bought a wonderful company at a fair price

"It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Warren Buffett

Related Article:

• It is Far Better to Buy A Wonderful Company at a Fair Price than a Fair Company at Wonderful Price

Simple Formula to Determine Intrinsic Value of a Stock

Actual Question:

Is there any simple strategy or formula to identify intrinsic value of a stock?

Answer:

Yes there is.

1. Multiply the earnings per share (EPS) by 15 and you will get one intrinsic value based on earnings.
2. Multiply the book value per share by 1.5 and you will get another intrinsic value based on value of assets.
3. The minimum of the two intrinsic values can safely be taken as the intrinsic value of the share of the company.

Since you asked a simple question I have given a simple answer, but do not make investment decision based on just the intrinsic value. There are many factor to be considered.

Suggested Further Reading:

• Earnings Per Share (EPS)
• Price to Earnings (PE) Ratio
• Price to Book Value
• How to Find The Fair Price of A Stock?

How to Calculate the Intrinsic Value of Shares?

Before deciding to buy stocks, an investor needs to know what is the value of the share he or she intends to buy first. This leads to questions like what is the meaning of intrinsic value, intrinsic value of a share and finally, "How to Calculate the Intrinsic Value Shares?". 

So let us address the concepts one by one.

Intrinsic Value

Every thing in this world has an intrinsic value. For example one 500 rupee note has a value of 500 one rupees. Not a penny more or, not a penny less.

But how can we say this with conviction?

Well will any same person take a 500 rupee note and exchange it for more than five 100 rupee notes? Similar will we accept four 100 rupee notes in return for a 500 rupee note?

Therefore we can safely conclude that the intrinsic value of a five hundred rupee note is equal to 500 one rupees or five hundred rupee notes.

Intrinsic Value of Share

As with the five hundred rupee note, a share also has an intrinsic value. Any wise investor, who knows the inherent value of a share will never buy the stock above it's intrinsic value. She will be glad to buy the share if it is trading in the stock market below its intrinsic value. Buy is an understatement, in fact, she will pounce on the opportunity and grab the shares with both her hands.

But, is it possible that shares can be available below their intrinsic values?

Of course yes!

The stock market is a highly irrational place.

Now the discussion is getting excited with the prospect of being able to buy stocks below their fundamental values, is it not?

So, now it is important for us to know how to calculate the intrinsic value of shares, and let us address the question.

Calculating Intrinsic Value of a Share

The intrinsic value of the share of a company is essentially calculated based on two factors as follows:

1. Price to Earnings (PE) Ratio
2. Price to Book Value (P2BV) Ratio

Example Calculation of Intrinsic Values of Shares of NMDC and SJVN

Let us consider a live example of SJVN Ltd. and NMDC Ltd., based on the facts existing on 23rd September 2016.

In case of NMDC Ltd., to be on the safe side we have taken the minimum of the two intrinsic values of Rs.68.80 and 113.34, and rejected it. However please note that NMDC Ltd. is a wonderful company. I continue to buy its shares even today. Its PE Ratio deteriorated on account of two recent and temporary developments as follows:

1. The EPS deteriorated steeply on the back of a meltdown in global commodity prices. The price of iron ore has recovered to a great extent and I firmly believe it regain further.
2. The Indian stock markets have rallied in the recent past and pushed up the prices of all the shares across the board, which has pushed up the PE Ratio.

Caution:

Investment decisions are not simply based on the intrinsic value calculations shown above. A rigorous investigation of the company’s performance and prevailing market conditions described in the article “What are the Factors to be Considered Before Investing in a Company?”.

Related Links:

• How to Find The Fair Price of A Stock?
• What is 'Price to Earnings Ratio'? - Presentation
• How to Calculate ‘Price to Earnings Ratio?
• How to Calculate 'Earnings Per Share' or 'EPS'?
• Definition of Book Value per Share
• What is ‘Price to Book Value? - Article

Conclusion

To conclude, Price to earnings and Price to Book Value Ratios are the two key metrics employed in finding the intrinsic value of the shares of a company. We also learnt how to calculate the intrinsic value of share.

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 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.

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:

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

• Margin of Safety
• Where to Find Industry Wise Price to Earnings Ratios for Indian Stocks?
• How to Calculate the Intrinsic Value of Shares?
• Buy Wonderful Stocks at Fair Price
• It is Far Better to Buy A Wonderful Company at a Fair Price than a Fair Company at Wonderful Price
• You Only Find Out Who is Swimming Naked When The Tide Goes Out

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.