How much should one share cost?
When you buy anything, you want to know whether or not the price is fair. There are two terms often used to assess whether the price of share is good. One is "fair value" and the other is "target price". However there is a big difference between these terms. The fair value is based on the value of one share, while a price target estimates how much other investors would be willing to pay for one share.
Calculating Fair Value
Morningstar (invested.ch data supplier) uses a discounted cash-flow model to calculate the Fair Value based on the company’s balance sheet. The assumption is that a share’s value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present. So, the first step is to project how much cash a firm is likely to generate over a number of years, and subtract the amount needed for capital improvements and increases in working capital to keep the business growing. Whatever profits are left over belong to the shareholders. The second step is to discount those profits to understand how much they are worth today.
Calculating Target Prices
Target prices are usually developed by making an estimate of what a company’s earnings will be in the future and then applying a multiple, usually a price-earnings ratio (P/E ratio). Theoretically, the P/E ratio shows how much investors are willing to pay for $1 of company earnings. Therefore, a price target is an estimate for the future. Target price analysts multiply their earnings estimate per share by the P/E ratio. For example, if a company’s earnings estimate for the year is 1.10 per share. If the P/E is 60, then the target price will be $66.
The difference is that Fair Value is based on a company balance sheet, while Target Prices focus on earnings forecast and how much shareholders are willing to pay for $1 of earnings today. Management is more cautious about reporting on their balance sheet. Target Price analysts tend to make adjustments to make earnings estimates look like economic returns. At the same time, the multiplier, P/E ratio, is based on current market sentiment of the stock.
Fair Value is a more conservative calculation of the price of one share. As long as we have an idea of what one share is worth, we are in a better position to determine whether a share is undervalued or overvalued.