A lot of talk has gone into figuring out how much an investment is worth. The goal of every investor is to find investments that are undervalued and sell them when they are worth what they should be. This is the hardest part of investing, no doubt. What, then, is fair value? Fair value is when the price of an investment matches how much money it can make.
Fair value is subjective and depends on things that investors can't change. Here, we'll talk about how to figure out fair value within our own control. In short, the fair value of an investment is based on the expected rate of return and the risk taken to get that return. More risk needs a bigger payoff. It is quite simple.
So, what kinds of investments have less risk? We can only draw parallels. Certificate of Deposit is the first thing that comes to mind (CD). If you can hold on for a certain amount of time, you are guaranteed a certain return (interest rate). At the end of the time period, you would never lose your principal.
The next investment with low risk is a Treasury Bond. This is the US government bond, which is thought to be the safest investment in the world. There are some risks that come with the small changes in the price of bonds. But if you kept the bond until it was paid off, you would get a certain rate of return. Your rate of return will depend in part on how much you paid for the bond.
Buying common stock is the next riskier thing to do. Here, we'll pay more attention to this. It's riskier than the two types of investments we've talked about so far because you have a greater chance of losing money. We've already talked about how higher risk needs a higher reward. So, investing in stocks needs a bigger payoff.
So, what does this have to do with what something is worth? Simply put, the price of a common stock that we buy must give us a higher annual return than bonds or CDs. For instance, if a CD gives you a return of 3% and treasury bonds give you a return of 4%, you would want your stock to give you a higher return, like 6%.
What does it mean when an investor gets a 6 percent return on a stock? It doesn't say that, does it? You have some points. Even though it's not made clear, you can find out how much your stock investment would bring back if you look around. For example, if you invest $100 in a Certificate of Deposit (CD) that gives you a 2% annual return, you would get back $2 every year. Let's say you want your stock to give you a return of 6 percent, which is higher than a CD or a treasury bond. This means that for every $100 we put into common stock, we need a return of $6 per year.
Where can we find these facts? You can find it on Yahoo! Finance or in other financial publications. All we have to do is find the share price of a common stock and its profit per share, which is also called its earnings per share. Let's use an example to illustrate my point. For fiscal year 2005, Magna International Inc. (MGA) is expected to make a profit of $6.95 per share. The share has been trading at $ 73.00 as of late. When you divide $6.95 by $73.00, which is the price of a share of Magna stock, you get the annual return. We get a return of 9.5% from this.
Will Magna continue to give investors a 9.5 percent return year after year? It depends. If the stock price goes up, Magna's return will be less than 9.5% per year. What else? Well, it's possible that Magna won't always make the same amount of money every year. It could even make you lose! So, you can see that buying stocks is risky because there are two things that can go wrong. The price of common stock and how much money the company makes for itself. This is why investors should try to get a higher return when they choose stocks to buy.
Certainly. So, let's get to the most important part of buying common stocks. How much should Magna stock be worth if it always makes $ 6.95 per share? I think that a common stock's fair value is at least 2% more than the rate of a Treasury bond. Note that I'm talking about the 10-year bond. Recently, treasury bonds have been able to give us a return of 4%. So, Magna common stock is worth what it's worth when it gives me a return of 6%.
So, what should Magna's common stock be worth in this case? If Magna's common stock makes a profit of $6.95 per share, its fair value is $115.80 per share. You're right. At $ 115.80 per share, Magna common stock gives investors a return of 6% per year. Even so, we shouldn't buy a common stock at its fair value. Why? Because our investing purpose is to make money. When do we make money if we buy stocks at their fair value? Do we think we'll be able to sell it when it's worth too much? Yes, it would be great if we could always do that. But to be safe, let's not put all our money on our stocks getting too expensive.
So there it is. I told you how to figure out the fair value of a common stock. The $ 6.95 per share profit number is, of course, Yahoo! Finance's estimate of how much money the company is likely to make. It doesn't mean that you should buy Magna common stock. You should do your own math to make sure that number is right.
