Why the Fair Value Estimate is a big deal

By Sarah Newcomb |  06-11-19 | 
 

High and low are meaningless without a reference point. 

You wouldn’t buy a car without knowing its Blue Book value (the Indian equivalent). You wouldn’t buy a house without an appraisal. Why would you buy shares in a company without knowing the Fair Value, or FV?

What you must know: Following the herd can lead to ruin

Investors can act like buffalo that follow one another somewhat blindly. For instance, a rumour starts that XYZ company is going to be the next Google or Amazon or Wipro and people start buying. As demand drives the price upward, the forecasts appear to be correct, and the herd starts a buying frenzy trying to get in before the peak.

What we call a market “bubble” is when this race-to-buy pushes the price significantly higher than the stock is actually worth, until no one is willing to buy at the inflated price.

At that point, someone starts selling at a slightly lower value so as to cash in at the peak. Bubble: burst. As the price drops, the herd panics, starting a selling frenzy that sends the price of the asset into the proverbial toilet.

Behavioural finance folks call this “herd behavior” for obvious reasons.

We’ve seen this play out time and time again.

  • Tulip Mania in Holland. In the 17th century, one tulip bulb sold for more than 10 times the average worker’s annual salary. In what Douglas-Adams-inspired universe is that reasonable? Ours, apparently. 
  • Railway Mania in the U.K. In the 1840s, Railway Mania broke out and many middle-class families lost their life savings when it became clear that the market had been overhyped.
  • Dotcom bubble. More recently, the dotcom bubble sent investors into bankruptcy when the first generation of Internet giants hit the rocks (Cisco lost 86%, for example) and others failed completely. 
  • Housing market bubble in the U.S. Then, of course, there was 2008, when the housing market in the U.S. grew out of control and then crashed suddenly. I watched as family members invested in properties in Phoenix, Arizona, hoping they would find another investor to buy them out within a few years. However, by the end of the real estate boom, it was just investors buying from one another without the demand for actual residents in the homes. Speculator sold to speculator until one poor sot was left holding the house-shaped bag.
  • NBFC bubble in India. Sometime back, non-banking financial companies were the darlings of the market. We can see how that is playing out.

In every case a few people grew very rich, but many, many more lost everything. Not knowing the true value of something leaves you vulnerable to this kind of catastrophic event. 

What you must know: Countering the herd can also fail

Because the herd is often wrong, some people adopt a contrarian rule of thumb. As Warren Buffett famously said, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."

This contrarian viewpoint has its merits, but without a reference price for comparison, contrarianism is equally unreasonable. Countering the herd’s behaviour or trying to predict what the herd will do next is still investing based on emotional guesswork, not fundamental analysis. 

In fact, Buffett’s statement above doesn’t mean that you should just watch the herd and do the opposite. Rather, it means that when the herd has abandoned a quality company out of fear, you can take advantage of the fact that they have driven down the price and invest while it’s effectively “on sale.” Another famous Buffett quote sums this up as, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it’s marked down.” 

Put differently, to make a good stock pick, you need to 1) know that a company’s fundamental value is solid, and 2) buy it when the market price is fair, or better, when it is selling at a discount.

To do this you need to have a FVE. 

What you must know: Focusing on the Fair Value Estimate helps

The FVE is a smart shortcut that can help you determine whether the price of a stock is high or low compared with its fundamental value--not hype, not fear. Calculating the FVE involves looking at a company’s financial statements and annual reports, and assessing the management structure, competitive advantage, and corporate governance. It estimates the future cash flows of the company and adjusts them to today’s dollars.

Based on that research, a value is calculated that estimates the value of the company and what one share of stock should sell for if no emotions or headlines or hype from talking heads were involved. Fundamental analysis is not perfect. It is an estimate, and there are uncertainties involved for sure, but it is a much more reasonable estimate of the long-term fair value of a stock than “Whatever people are willing to buy it for today.” 

What you must know: It is a Smart Shortcut

The FVE provides necessary context to help you survive the herd’s stampedes. Without a logic-based reference point, “low” and “high” are meaningless, but if you know the FVE, then you can buy when the herd’s price is low--relative to the FVE --or sell when it’s high.

While the FVE is just one of several data points you may want to consider, it is a start, and it beats focusing on herd behaviour or cable news hype.

Remember this: Whatever the herd may do, remind yourself that the FVE is a big freaking deal. It is a smart shortcut that can help you find great companies at bargain prices and avoid getting trampled by the investing herd.

This article initially appeared on Morningstar.com and has been edited for an Indian audience. 

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