Calculating a Value of Common Stock

Calculating a Value of Common Stock

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Calculating a Value of Common Stock

Calculating a Value of Common Stock

Many discussions have been devoted to research in the fair value of an investment. The objective of all investors is to find under-investment and sell it when it reaches fair value. Admittedly, this is the most difficult part of investing. So what is the fair value? The fair value is a point where the price of an investment reflects its earning capacity.

The fair value of stock is relative and depends on other factors beyond the control of investors. In this case, we will discuss the calculation of fair value within our own control limits. In short, the calculation of the fair value of an investment depends on the rate of return and the risk taken to achieve this performance. Higher risk needs higher reward. It is quite simple.

So what good are lower risk investments? We can only compare. The first thing that comes to my mind is the certificate of deposit (CD). You are guaranteed a certain return (interest rate), if you can maintain a certain pre-determined time. You never lose your capital at the end of the period.

The next investment is low-risk Treasury Bond. It is the bond issued by the United States government, which is deemed to be safest in the world. There are some risks associated with small fluctuations in bond prices. However, if you held the bond until maturity, you are guaranteed certain rates of return. Your rate of return depends to some extent on the price you bought the bond.

The next higher risk of investment is buying shares. That is what we are going to focus more here. This type of investment is measured a higher risk when compared to the two types of investments mentioned above because you're more likely to lose money on your investments. Earlier, we created a higher risk that needs higher reward. Therefore, stock investing requires a higher reward.

So what does this has something to do with fair value? Quite simply, the price of a stock that we buy we must give an annual yield more than bonds or CDs. For example, if a CD gives you a 3% return, treasury bills to give you a return of 4%, then you want your stock gives you a higher yield of around 6%.

What does this mean for a stock to give the stock investor a return of 6%? He never really said, is not it? You are somewhat right. Although not clearly stated, you can do a little digging and know how the return of your stock investment would be. For example, if your certificate of deposit (CD) gives you an annual yield of 3% to $ 100 investment, you can earn $3 every year. Let's say you want your stock to give you a return of 6% which is higher than a CD or bonds. This means for every $100 invested in common stock; it must give you a return of $6 per year.

Where can we get this information? You can get this information on financial websites like Yahoo! Finance or other financial publications. All you need do is find the share price of a common stock and earnings per share (EPS) for this stock. Let's use an example to illustrate this. XYZ International Inc (XYZ) is expected to show a profit of $ 6.95 per share for fiscal 2005. Recently, the share is $ 73.00 in trading. The annual yield of XYZ stock is $ 6.95 divided by the share price $ 73.00. This gives us a yield of 9.5%.

Will XYZ continue to give investors a 9.5 % return every year? It depends. If the stock price increases, XYZ will return less than 9.5% per year. What else? Well, XYZ could not consistently the same amount of profits every year. It could even produce a loss! So you see; stock investment is inherently risky because there are two moving part in the equation. They are Prices of common stock and the profits generated by the company itself. That's why investors should be aimed at higher return when selecting their stock investments.

So, let's get to the point of investing in common stocks. What is the fair value of XYZ stock assuming a profit of $6.95 per share? Let's assume the fair value of a common stock of at least 2% above the rate of Treasury bond. Please note that using the 10 year bond here. Recently, the treasury bonds can give us a return of 4%. Therefore, the fair value of XYZ common stock is when it can give me a yield of 6%.

So what is the fair value of XYZ common stock in this case? For a profit of $ 6.95 per share, the fair value of XYZ common stock is $ 115.80 per share. That's right. At $115.80 per share, XYZ common stock will return investors 6% per year. However, you should never buy a common stock at fair value. Why? Because, our goal of investing is to make money. If we buy stocks at fair value, then what do we benefit? Do we expect to sell when it is overvalued? Of course it would be nice if we can do this all the time. But to be careful, let's not bank on our stocks reaching overvalued level.

There you go. It's explained how to calculate the fair value of common stock. Of course, the $6.95 earnings per share profit figure is the expectation of profit compiled by Yahoo! Finance. It is by no means an endorsement to buy XYZ common stock. You should do your own calculation to verify this figure.