When investing in an equity asset, most people look at its market value or the value at which it is currently trading in the market. However, a crucial parameter that they often ignore is the fair value of shares. If the stock market experts are to be believed, one should always compare the fair value of the stock with its market value while making investment decisions.
But do you know what is the fair value of the stock? How does it differ from the market value? How do you calculate the stock’s fair value? This blog tries to answer all such questions in detail. Keep reading.
What is the fair value of shares?
The intrinsic value of a security or an asset is known as the fair value. In other words, the fair value is the estimated worth of a security, particularly stocks, commodities, etc., based on the objective criteria. Considering its fundamentals and prevailing market conditions, it reflects what an informed buyer would be willing to pay for the asset. Unlike market price, which can be influenced by emotions, speculation, and other extraneous factors, fair value seeks to determine the underlying value of an asset.
Fair value vs market value
Fair value represents the intrinsic worth of the stock to an investor. On the other hand, the market price denotes the current trading price on the exchanges. Consequently, the fair value tends to change gradually based on the stock’s underlying fundamentals. In contrast, the market value is susceptible to significant fluctuations driven by short-term and long-term market perceptions and influences.
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For example, the HDFC stock has traded within a broad range of Rs. 1,363.55 to Rs. 1,757.50 over the past year. It highlights the substantial variability in the market price of the stock. This volatility can be caused due to a multitude of factors such as macroeconomic indicators, geopolitical events, and the company’s operational performance.
As an investor, you must gauge the stock’s market price against your fair value assessment. If the estimated fair value of a share surpasses the prevailing market price, it suggests a potential buying opportunity. Conversely, if the fair value falls short of the current market price, it may indicate a selling opportunity.
How do you calculate the stock’s fair value?
While there are various methods to calculate the fair value of shares, one commonly used approach is the discounted cash flow (DCF) analysis. The DCF model estimates the present value of a company’s future cash flows, considering factors such as projected earnings, growth rates, and the risk associated with the investment.
The formula for calculating the fair value using DCF is as follows:
Fair Value = Σ [CFt / (1 + r) ^ t]
Here, Σ represents the sum of all future cash flows, CFt is the cash flow in the specific year, r is the discount rate, and t is the number of years for which the cash flow is being calculated.
Another popular method to calculate the fair value of shares is the market value analysis. This approach involves leveraging market prices of similar securities to determine the fair value for the stock. For instance, valuation metrics and stock prices of competitors, such as ICICI Bank, Axis Bank, and Kotak Mahindra Bank might help you assess the fair value of HDFC Bank stock.
Advantages of fair value
Below are the advantages of analysing the fair value of stocks:
Informed decision making
By focusing on fair value, you can make more rational and objective investment decisions that are less likely to be swayed by short-term market fluctuations or hype surrounding a particular stock.
Risk management
Investing based on fair value helps mitigate risks associated with overvalued or undervalued stocks. It promotes a disciplined approach to buying stocks at prices justified by their fundamentals.
Long-term perspective
Fair value investing encourages a long-term perspective. Instead of chasing short-term gains, you can concentrate on the company’s intrinsic value, which often leads to more sustainable returns over time.
Fair value investing provides a systematic framework for evaluating stocks based on their intrinsic worth. By focusing on a company’s fundamentals, you can make more informed decisions and build resilient portfolios.
