Fair Value of A Common Stock

Many discussions are devoted to finding the fair value of an investment. The goal of every investor is to find undervalued investment and sell it when it reaches fair value. Admittedly, this is the hardest part of investing. So, what is the real value? The fair value is a point where the price of an investment reflect its profitability.

The fair value is relative and depends on other factors beyond the control of the investors. Here we will discuss about how to calculate the fair value within our own borders of control. In short, the calculation of the fair value of an investment depends on the expected return and the risk taken to achieve that. Return Higher risk needs higher reward. It's very simple.

So, what assets are lower risk investments? We can only compare. First thing that comes out of my mind is Certificate of Deposit (CD). You are guaranteed certain return (interest), if you can keep for a certain period of time set in advance. You would never lose your principal at the end of the term.

The next low risk investment is Treasury Bond. This is the bond issued by the U.S. government, which is considered safest in the world. There are certain risks associated with the small fluctuations in the price of the bond. However, if you held the bond to maturity, you are guaranteed certain return. Your return depends to some extent on the price you bought the bond at.

The next higher investment risk purchase ordinary shares. This is what we are going to concentrate more here. It is considered a higher risk than the two types of investments mentioned previously because you have a higher chance of losing money on your investments. Previously, we found that higher risk needs higher reward. Therefore, stock investing requires a higher reward.

So, what does this have anything to do with the real value? Quite simply, the price of a common stock that we buy should give us a higher annual return than bonds or CD. For example if a CD gives you a 3% return, treasury bonds give you a 4% return, then you would want your stock gives you a higher return of perhaps 6%.

What does it means for a stock to give investor a return of 6%? It never really say, right? You are partly right. Although not explicitly shown, you can do a little digging and find out how much the performance of your stock would be investment. For example, if your Certificate of Deposit (CD) gives you a 2% annual return, for $ 100 of investment, would earn $ 2 per year. Let's assume that you want your stock to give you a return of 6%, which is higher than CD or treasury bond. This means for every $ 100 invested in common stocks, it needs to give us a return of $ 6 per year.

Where we can provide this information? You can get it on Yahoo! Finance or other financial publications. All we have to do is find the share price of ordinary shares and earnings per share (also known as earning per share) of that particular stock. Let's use an example to illustrate my point. Magna International Inc. (MGA) expected a profit of $ 6.95 per placing share for fiscal year 2005. Recently, the share of trade at $ 73.00. The annual return of buying Magna stock is $ 6.95 divided by the price of $ 73.00. This gives us a return of 9.5%.

Magna will continue to give investors a 9.5% return year after year? It depends. If the share price rises, Magna will be less than 9.5% per year return. What else? Well, Magna might not constantly produce the same amount of profit year after year. It may even produce a loss! So you see, stock investing is inherently risky, because there are two moving part in the equation. Price of the ordinary shares and profit by the company itself. That is why the investor should seek a higher return when choosing their inventory investment.

Okay. So, let's move on to the crucial point in investing in common stocks. What is the fair value of Magna stock assuming a constant profit of $ 6.95 per share? Personally, I reject the fair value of an ordinary share to at least 2% above the rate of Treasury bond. Note: I use the 10-year loan here. Recently, treasury bond can give us a 4% return. Therefore, the fair value of Magna common stock is like me a return of 6%

So, what is the fair value of Magna common shares in this case? For a profit of $ 6.95 per share, the fair value of Magna common stock is $ 115.80 per share. That's right. At $ 115.80 per share, Magna common stock investors 6% annual return. That said, we never have to buy at fair value. Ordinary shares Why? Because our goal is to invest money. If we buy shares at fair value, when we benefit? We do expect to sell it when it is overvalued? Sure, it would be nice if we can do all the time. But to be conservative, let's not get on the couch our stocks overvalued level.

There you go. I explained how to calculate the fair value of a common stock. Of course, the $ 6.95 per share profit figure is the expectation of profit compiled by Yahoo! Finance. It is in no way to buy. Approval of Magna common shares You should do your own calculation to that number to check.

Hari Wibowo manages a modest investment website aims to help to go to work. People Curious to find the fair value of a common stock? A more detailed analysis can be found