Yan Barcelo, a veteran financial and economic journalist, tackles this in Morningstar.ca. Below is an excerpt.
Some types of investors don't really care for "fair value", notably momentum-style investors and, very often, growth investors. But for value-style investors, it is crucial and amounts to determining the "intrinsic value" of a stock.
Damien Conover, director of health care research at Morningstar in Chicago, is such an intrinsic value miner. As he explains, finding that value involves performing an analysis of future cash flows and discounting them by the average cost of capital. Of course, identifying future cash flows can involve loads of details: competitive dynamics, industry-specific costs, revenue projections, management features, etc.
The "intrinsic value" such an analysis delivers serves to estimate if the stock's price is high, low or... fair. Yet, that can still lead to almost opposite perspectives on the market. Two value-style portfolio managers to which I recently spoke perform approximately the same discounted future cash flow analysis. One concludes that he can't find low prices anymore and is hoarding cash in preparation for a coming correction; the other one still sees attractive opportunities.
Such apparent contradictions hinge on features that hold considerable uncertainty, explains Steve Rogers, investment strategist at Investors Group in Toronto. "Each company has unique characteristics that make its future uncertain," he says. Fair value is hard to nail down simply because the future is not a neat picture you can hang on a wall.
Analysts and portfolio managers usually perform an intrinsic value analysis on a company-by-company basis, but boosting that analysis to encompass the whole S&P500 could be highly informative. It could supply a better perspective on market prices because, contrary to Shiller's index which is backward-looking, it would be forward-looking. And that is very nearly what Morningstar has set up with its "market fair value" ratio, which calculates a fair value ratio for all the stocks that Morningstar analysts cover. It's not quite a total market index, but it still covers thousands of stocks. Now, lo and behold, standing at 0.93, that Morningstar market fair value ratio presently confirms Steve Rogers's view that markets are really not that expensive (at 1.00, the ratio would consider that stock prices are just right).
A better way to deal with "fair value" could be to think in terms of "rational expectations", as Jean-Philippe Tarte, faculty lecturer at HEC Montréal, suggests: "A fair price often appears as just any price that the market is ready to pay. But that doesn't mean the price is rational."
Such a "rational price" could present itself as a price range that would support "rational" expectations of future returns. Quite interestingly, Robert Arnott, founder and chairman of Research Affiliates, LLC, in California, addresses the issue from the perspective of bubbles. A bubble, he claims, is in force when "you need to make implausible aggressive assumptions about future revenues to justify present valuations. Apple's stock price is not in a bubble, because you don't need implausible assumptions to justify its price. But for Twitter, Netflix and Tesla, you need implausible assumptions."
A brief look at how Morningstar views it.
To derive the fair value estimates, we use our proprietary discounted cash-flow, or DCF, model. This model assumes that the stock's value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present. So, the first step is to project how much cash a firm is likely to produce over a number of years, and subtract the amount needed for capital improvements and increases in working capital to keep the business growing. Whatever profits are left over belong to the shareholders. The second step is to discount those profits to understand how much they are worth today.
As with any DCF model, the ending value is highly sensitive to the analyst's projections of future top- and bottom-line growth. In addition, the cost of capital, which is determined by the firm's capital structure and its riskiness, is another influential factor in the fair value estimate.
The Morningstar fair value is based on how much we believe the stock is worth, while a target price estimates how much other investors are willing to pay for the stock. This divergence emerges because we at Morningstar tend to assess stocks differently than Wall Street evaluates them.
Morningstar's fair value estimates aren't meant to be automatic buy or sell indicators. To determine reasonable buy and sell prices, we look at a stock's margin of safety. We like to buy when a stock's fair value estimate is considerably more than its market price. This is important because buying when the stock is trading at a discount protects the investor just in case the fair value estimate is too optimistic.
On the other hand, when the market price has climbed far above the fair value estimate, this may be an indication that the stock is overvalued and potentially vulnerable to any hiccups that might come along.
