What Does It Mean When a Stock is Fairly Valued?

One of the most misunderstood of all investment issues is what it means when shares of stock in a business are fairly valued.  When investors hear that a stock is fairly valued they inevitably treat that stock as if it is over valued – avoiding a purchase in that business.  However, that is not what the term fairly valued means.

To understand the issue a brief overview of stock valuation is necessary.

The primary driver of value in a business is growth in the earnings/profit stream of a business.  Sans growth in profits there wouldn’t be much of a reason to invest in a company’s stock.  Why?  It’s not that the business is necessarily a dying business, as there are many slow growth businesses out there.  No, it’s just that why as an owner of capital in a business that only generates flat, steady cash flow why would I take on the additional risk of owning a company’s stock when I could own capital in the business as a bond holder?  In other words, sans growth in profits, there isn’t too much of a reason to own stock rather than the bonds of a business.

Inherent to every valuation of a company’s shares of stock is an implied growth rate in the earnings stream.  That growth results in a valuation for the business that is considered “fair value.”  So a business that is trading at a discount to fair value is an investment opportunity where gains can be had from two sources: the earnings growth in the business and (hopefully) a trending back to what you feel is fair value.  Conversely, a stock that is overvalued presents a mixed picture with regard to making money in the investment.  That is, you may make money from the profit stream that the business generates, but you may also lose money as the price per share of the company’s stock trends back down to fair value.

So you see, what it means when a stock is trading at fair value is that you are not going to make additional money from a trending back up to fair value.  Therefore, all of the return that is likely to be generated by owning shares in the business is going to be from earnings growth.  For example, last week I wrote a piece stating that I thought that Apple was slightly overvalued.  What that means is that there is the value that will accrue to me from Apple’s earnings growth, but there is also a chance that appreciation will be offset by shares of Apple trading down in value if investors sell it back down to fair value.  Does this make sense?

Buying shares of stock in a business that are trading at a discount to fair value is what is known as a “margin of safety.”  That additional source of return, shares trading back to fair value, cushions your returns in case your estimate of the earnings growth of the business has been overestimated.  This is another way of saying that so-called “value” investors clearly still care about the earnings growth of the business.  It’s just that they try and invest in businesses where money can be made from both earnings growth and a rise back to fair value.

To buy shares of stock in a business trading at fair value means that it is highly likely that all of your return will be generated by earnings growth, and that there will be no excess return from the shares trending upward from an undervalued position.  Thus, when you are investing in stocks, a company selling at fair value may still generate plenty of return for you, but those returns will be constrained by earnings growth.  If you are happy with the earnings growth implied in that fair value calculation, then you can still make a return in the stock, just not excess return.

Jason