How to Estimate Stocks' Fair Values
How do analysts arrive at fair value estimate for a stock, and how do they relate to the stocks rating? To determine a stock's fair value, analysts examine factors such as estimated future cash flow, competitive positioning, and even the degree of certainty the analyst has in making his or her evaluation.
Analysts typically track companies within specific sectors and revise their fair value estimates whenever information becomes available that affects their outlook for a stock. A new product launch, a merger or acquisition, or a major competitor abandoning a market are some examples that could cause an analyst to revise a company's fair value estimate up or down.
The process on how analysts arrive at a fair value estimate is outlined below.
The first thing the equity analyst does is examine the company's fundamentals: sales, revenue, expenses, and so on. These are gathered from financial statements, industry reports, discussions with company management, trade-show visits, and other sources.
Once the fundamental analysis is completed, the analyst proposes a rating of competitive advantage over its competitors for the stock. Analysts propose a moat rating of wide, narrow, or none for a company to determines that rating.
Next, the analyst looks at historical data, along with the company's competitive position and future prospects, to forecast future cash flow. All this data is applied to a proprietary discounted cash flow model to arrive at a fair value estimate for the stock. Due to the specific characteristics of certain industries, special models exist for valuing the industries. This fair value estimate represents what equity analysts believe the stock is currently worth.
Once the fair value estimate is established, the next step is to determine a level of confidence in the estimate, which can vary based on factors such as volatility within the company's industry, economic sensitivity, and other variables that could affect the stock's price in the future. The analyst assigns an fair value uncertainty rating to the stock, which helps determine the margin of safety (or cushion to account for multiple potential outcomes) analysts believe is necessary to recommend buying or selling it. The upper and lower bounds of this margin of safety are determined by a formula that is applied to all stocks based on their uncertainty ratings. A stock with a low uncertainty rating requires a relatively low margin of safety.
The last piece of the process is the rating for stocks, which reflects where a stock's current share price stands relative to fair value estimate. A stock with the highest rating is selling at a deep discount while a stock with the lowest rating is very overpriced. The rating thresholds are also the points at which the recommended Buying and Selling prices kick in. A stock's rating can change daily based on its closing price.
