Fair Value of A Common Stock

916
A lot of discussions have been devoted towards finding fair value of an investment. The goal of every investors is to find undervalued investment and sell it when it reaches fair value. Admittedly, this is the hardest part of investing. So, what is fair value? Fair value is a point where the price of an investment reflect its earning power.
Finance Stock Annual Report Web Directory Article Submission Link Popularity
A lot of discussions have been devoted towards finding fair value of an investment. The goal of every investors is to find undervalued investment and sell it when it reaches fair value. Admittedly, this is the hardest part of investing. So, what is fair value? Fair value is a point where the price of an investment reflect its earning power.

Fair value is relative and it depends on other factors beyond the investors’ control. In here, we will discuss on calculating fair value within our own boundary of control. In short, calculating fair value of an investment depends on the rate of return expected and the risk taken to achieve that return. Higher risk needs higher reward. It is quite simple.

So, what asset constitute 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 rate), if you can hold for a certain pre-determined time frame. You would never lose your principal at the end of the time frame.

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

The next higher risk investment is buying common stock. This is what we are going to focus more here. It is considered higher risk than the two types of investments mentioned previously because you have a higher chance of losing money on your investments. Earlier, we established that higher risk needs higher reward. Therefore, stock investing requires a higher reward.

So, what does this have anything to do with fair value? Quite simply, the price of a common stock that we buy must gives 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 it, doesn’t it? You are partly right. While it is not explicitly shown, you can do a little digging and find out how much the return of your stock investment would be. For example, if your Certificate of Deposit (CD) gives you a 2% annual return, for $ 100 of investment, you would earn $ 2 every 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 implies for every $ 100 invested in common stock, it needs to give us a return of $ 6 annually.

Where can we get this information? You can get it on Yahoo! Finance or other financial publications. All we need to do is find the share price of a common stock and the profit 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) is expected to post a profit of $ 6.95 per share for fiscal year 2005. Recently, the share is trading at $ 73.00. The annual return of buying Magna stock is therefore $6.95 divided by its share price $ 73.00. This gives us a return of 9.5%.

Will Magna continue to give investors a 9.5 % return year after year? It depends. If the stock price rises, Magna will return less than 9.5 % annually. What else? Well, Magna might not constantly produce the same amount of profit year after year. It might even produce a loss! So, you see, stock investing is inherently risky because there are two moving part in the equation. Price of the common stock and the profits produced by the company itself. That is the reason why investor need to aim for higher return when choosing their stock investment.

All right. So, let’s move on to the crucial thing in investing in common stock. What is the fair value of Magna stock assuming a constant profit of $ 6.95 per share? Personally, I assign fair value of a common stock to be at least 2% above the rate of Treasury bond. Please note that I am using the 10 year bond here. Recently, treasury bond can give us a 4 % return. Therefore, the fair value of Magna common stock is when it can give me a return of 6%

So, what is the fair value of Magna common stock 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 will return investors 6% annually. Having said that, we should never buy a common stock at fair value. Why? Because our investing purpose is to make money. If we buy stocks at fair value, then when do we profit from it? Do we expect to sell it when it is overvalued? Sure, it would be nice if we can do that all the time. But to be conservative, let’s not bank on our stocks reaching overvalued level.

There you go. I have explained how to calculate fair value in a common stock. Of course, the $ 6.95 per share profit figure is the expectation of profit compiled by Yahoo! Finance. It is not in any way an endorsement to buy Magna common stock. You should do your own calculation to verify that number.

Technorati Tags: , , , , , , , , ,

Penny Stock Returns

Why do people invest in penny stocks if they are so risky? The answer lies in a few facts as well as a few misconceptions about penny stocks. First let us look at the positive side of how penny stocks can be more profitable.

It is a well-known fact in finance that risk and return have a positive correlation. This means that an investment that carries greater risk will also give higher returns. The reason for this is very easy to understand and is almost intuitive. Suppose you had $10,000 to invest and two options A and B. Option A is a secure government bond that gives you 5% return, while option B is a higher risk investment in a company that will pay you only if it makes profits. Assume that this company has a history of making 5% Profits over several years and is likely to continue on the same lines.

That is, you can expect to get a return of 5% in future years, but that is subject to the company making the same level of profits. Where would you invest your money? If the returns are likely to be the same and if you are a sane person, you would obviously invest in the risk free option. Now suppose, option B were to pay you not 5% but 15% consistently, you might be tempted to put your money in it. In other words, a higher return can make you to invest in a riskier venture.

Since penny stocks are higher risk alternatives compared to regular stocks, the only way they can attract investment is by holding out a promise of higher return. How would a penny stock offer a higher return? This will be done not directly by the stock or the company, but by market forces. The market price of a stock is fixed on the basis of a few factors such as its intrinsic value and the return yielded by it. The market price of a stock divided by the return it gives is known as the price-earnings ratio.

For example, if $10 stocks were to be traded in the market at $20, and the company earns a net income per share of $1, the price-earnings ratio is 20. The price-earnings ratio will be higher for solid stocks that are known to be backed up by good management, have a history of consistent and good performance, and are perceived to be stable. The price-earnings ratio for stocks that are riskier, unknown and do not enjoy a positive perception will be much lower. This means that as against the example of price-earnings ratio of 20 that we assumed for a stable and well-known stock, a penny stock may have a much lower price-earnings ratio, say 3 or 4. Actual figures will depend on a number of other factors also.

Because of this, a penny stock will be priced lower for the same level of net income, and will therefore yield a higher return on the investment.

Technorati Tags: , , , , , , , , ,