How to Calculate the Fair Value of a Stock

What fair value means

A share has two prices. The market price is what it costs today on the PSX. The fair value (also called intrinsic value, or the "fair price") is what you estimate it is really worth, based on what the company earns, how fast those earnings may grow and how risky they are. If your fair value is above the market price, the stock may be undervalued. If it is below, it may be overvalued.

Fair value is an estimate, not a fact. Two careful investors can reach different numbers for the same company, because they make different assumptions. The point of calculating it is not to find an exact price. It is to force yourself to ask: what do I have to believe about growth and risk for today's price to make sense?

Method 1: the P/E ratio (the quick check)

The price-to-earnings ratio compares the share price with the earnings per share (EPS). To get a fair value, flip it around: fair value = EPS × a reasonable P/E.

Which P/E is reasonable? A common starting point is the average P/E of similar companies in the same sector, or the company's own average over several years. For example, if a company earns an EPS of Rs. 20 and similar companies trade at about 8 times earnings, the P/E method gives Rs. 20 × 8 = Rs. 160.

Strength: fast and easy to explain. Weakness: it ignores growth and assumes the market's own multiples are right. See our guide to ratio analysis for how to read the P/E.

Method 2: the Graham formula

The investor Benjamin Graham proposed a simple formula: fair value = EPS × (8.5 + 2 × g), where g is the expected annual growth in EPS over the next several years, as a percentage. It was designed for a different interest-rate world, so it can give very high values when growth is high, as you will see below. Use it as a ceiling check, not an answer.

Method 3: discounted cash flow (the careful method)

A company is worth the earnings it will produce in the future, brought back to today's money. A rupee next year is worth less than a rupee now, because you could earn a return on it in the meantime. The steps, which our calculator follows:

1. Start with the EPS for the last twelve months (or your expected EPS).
2. Project it forward for a number of years at the growth rate you expect.
3. Add a terminal value: what the earnings are worth after the growth period, assuming they keep growing slowly, at a lower long-term rate, forever.
4. Discount each year's earnings and the terminal value back to today at the return you require (the discount rate).
5. Add them up. The total is the fair value per share.

The discount rate should be higher than the safe return you can earn elsewhere, such as government securities or a bank deposit, because a share is riskier. In Pakistan those safe returns have been high, which pushes fair values down, so always check current rates when you choose the discount rate.

A worked example

Take an imaginary company with an EPS of Rs. 20. We assume the EPS grows by 10% a year for 5 years, then by 5% a year forever, and we require a 15% return (the discount rate).

Now see how much the answer moves when only the assumptions change. Same company, same EPS:

Small changes in growth or the required return move the answer by tens of percent. That is the most important lesson of fair value work: look at a range, not one number. For the same imaginary company, the P/E method gave Rs. 160, the discounted cash flow about Rs. 256, and the Graham formula (with 10% growth) Rs. 570. The methods disagree because they answer slightly different questions, which is why you compare them.

Method 4: the dividend discount model

For companies that pay steady dividends, you can value the shares by the dividends they pay: fair value = next year's dividend ÷ (required return − dividend growth rate). If our imaginary company pays a dividend of Rs. 8 a share next year, grows it by 5% a year and you require 15%, the value is Rs. 8 ÷ (0.15 − 0.05) = Rs. 80. Our Dividend Discount Model calculator does this for you. It only suits companies with a reliable dividend history, and it gives a lower value than an earnings-based method when a company keeps much of its profit.

Where to find EPS and growth

• EPS: in the company's annual or quarterly report, in the profit and loss statement. Our guide to reading a PSX annual report shows exactly where to look.
• Growth: look at how the EPS has grown over the last three to five years, then be more cautious than the past. Growth rarely stays at its peak.
• Required return: start from the return on safe government securities and add a margin for the risk of owning a share.
• The market price: the latest closing price is on each company page. Prices here are end-of-day, not live.

Common mistakes

• Using a one-off profit. If last year's EPS included a gain from selling an asset, it overstates what the business normally earns. Adjust it, or use an average.
• Assuming high growth for too long. Very few companies grow fast for ten years. Use a shorter growth period and a modest long-term rate, below the growth of the economy.
• Trusting one number. Always check two methods and a range of assumptions.
• Ignoring the business type. Banks, cyclical sectors such as cement, fertilizer and oil and gas, and loss-making companies need different handling. A cyclical company's EPS at the top of its cycle is not a normal year.
• Treating fair value as a buy signal. A stock below your fair value can still fall, and a stock above it can keep rising. It is one input to a decision, not the decision.

Use the calculator

Our free fair value calculator does the discounted cash flow for you. Pick a PSX stock to fill in its last closing price, enter the EPS, your growth rate, a long-term growth rate, the required return and the number of years, and it shows the fair value, a year-by-year table and how far the market price is above or below it. No signup is needed. To see how a company's price has behaved, open its page from the list of PSX companies, or test the stock with risk statistics.

This guide is for education only and is not investment advice. The company in the worked example is imaginary.

Questions and answers

What is the fair value of a stock?

The fair value, also called intrinsic value or fair price, is an estimate of what a share is worth based on the company's earnings, growth and risk, as opposed to the price the market is asking today. If the fair value is above the market price the stock may be undervalued, and if it is below, it may be overvalued.

How do I calculate the fair value of a stock?

The simplest way is to multiply the earnings per share (EPS) by a reasonable price-to-earnings ratio. A more careful way is a discounted cash flow: project the EPS forward at a growth rate, add a terminal value, and discount everything back to today at the return you require. Our free calculator does the second method.

Is fair value the same as fair price?

In everyday use, yes. People searching for a "fair price calculator" usually mean a fair value calculator: a tool that estimates what a share should cost, to compare with what it costs on the market.

Which fair value method is the most accurate?

None is accurate on its own. Every method depends on assumptions about growth and risk, and different methods give different answers for the same company. Use two or three, look at the range, and treat the result as a rough guide, not a target.

Can I use these methods for banks and cement companies alike?

The arithmetic is the same, but the inputs differ. Banks, cyclical companies such as cement or oil and gas, and companies with one-off profits need extra care when choosing the EPS and the growth rate.

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