Why do stock price and fair value differ?
Stock price and fair value. Very common words in the stock market. Maybe you are new to the stock market. Perhaps you’ve just started investing and are interested in finding out more about these common terms, stock price and fair value. This article will help you differentiate between the two and look at how to analyze the stock price and determine fair value.
The Role of the stock market.
This article would be off to a terrible start if we did not touch upon the role of the stock market first. This is because the stock market is where both stock price and fair value find their expression.
The most important role of any market is to facilitate trade. At its foundation, the stock market is a two-way auction process. It avails potential buyers and sellers the opportunity to meet parties willing to be counter-parties to their respective transactions.
The motives of buyers and sellers are virtually infinite. In a traditional auction process, it goes one way. To explain how this seemingly, complicated process works, let’s make use of an illustration.
If an auctioneer is trying to get an auction started at ₦50, what happens if nobody will bid at ₦50? The auctioneer will have to lower the bid to attract an offer. The auctioneer lowers the bid to ₦40 and the bidding starts; ₦41, ₦41.50, ₦42, etc. and sometimes it will rip through the original ₦50 that no one would lift the bid for to begin with.
Let us say you come in with a mandate to buy this asset and you meet this auction process when the bid is at ₦55. You have done your research and you think, “Wait? My research proves this asset is not worth more than ₦35”! You are about to take a leave and suddenly, you hear the auctioneer say, “new bidder at ₦60”! What do you think will run through your mind?
It doesn’t make any difference what you think the value is, that auction will continue and if you need to own that asset, you’d better get your groove on and try to understand this auction and ultimately make a bid. This is how markets operate.
Stock Price as a reflection of the market sentiment
Many people think a stock with a cheap price is worth less than one that has a higher price and, therefore, a poor investment.
In reality, the price of a stock doesn’t really tell you much about its value. You also don’t know, by a stock’s price whether it is likely to go up or down. Or whether you will make money from that investment.
Often the cheapest stocks carry more risks than the not so cheap stocks. If you notice that a stock has dropped dramatically, it’s likely to continue falling and could end up at ₦0. A stock that is slowly increasing is more likely to continue with an upward trend.
The stock’s price only gives buyers and sellers a sign of its current value, as determined by most participants in the market. It reflects the sentiment of those participants at a particular time. It’s a good idea to look at a stock’s price and consider other factors such as supply and demand. The stock’s fair value is usually higher or lower than its market price.
Fair value as a reflection of valuation metrics
So, if the market exists to facilitate trade and the current market price reflects the market sentiment of most participants present at that auction, what is fair value?
Fair value is a measure of how much a stock is worth and is an acceptable rate. The fair value of a stock often stays at around the same level and doesn’t go through fluctuations as the stock price does. To understand fair value, let us use another illustration.
Mr. A and Mr. B are two intelligent investors. They both conducted thorough and rigorous research and have determined what they believe stock of ABC should cost. The current market price of ABC is ₦1,000.
Mr. A and Mr. B meet at their broker’s office and have a brief conversation. It goes like this.
Mr. A: “ABC is worth ₦700 a share. The market overvalues it,”.
Mr. B: “Nope! I disagree. I am certain a share of ABC is worth ₦1,500. The market undervalues it,”.
This disagreement of opinions is commonplace in the stock market. Let’s think about why this is so.
Investments require an initial cash outflow with an expectation of a future income stream (inflow). That initial outflow poses a challenge. How do I know what the accurate cash outflow, for these expected future incomes, should be right now? How do I determine the fair value, today, of this stock?
After an investor has determined what the fair value of an asset is, they make a comparison between the fair value and current market price of that asset. If the current market price is higher than the calculated fair value, they say the market is overvaluing the asset. Hence, the asset is overvalued and vice versa.
If a stock, for example, is trading at ₦20 and I, as an investor, calculate a fair value for the stock to be ₦10, I would conclude that the market overvalues the stock and I would not buy the stock at the current market’s valuation. If I owned that stock, I would be happy to sell it.
In an ideal world, the price would always reflect the fair value of the asset. Fortunately, or unfortunately, depending on which side of the argument you are on, this is usually the exception, not the norm. Many reasons cause the decoupling of price and value. As an illustration, GTBank stocks on the Nigerian Stock Exchange currently trade at ₦22.85 while the fair value is ₦36.26 using the Investor Hangout’s proprietary valuation model. (If you would like to try the Investor Hangout service to get access to the fair value of Nigerian listed stocks, please sign up for a free trial.
Why do different investors have different fair values for the same asset?
The principal reason that different people get differing fair values for the same asset is that there are different people calculating the fair value of the asset. Why, you may ask? It is because of the influence of time on an investor’s decision-making process. Not everyone that is taking part in the market has the same time perspective. We both may be in the market at the same time but you may buy because you’re planning on selling a month later whereas I may buy because I plan to hold on to that transaction for the next five years.
You should immediately appreciate that each of these individuals will behave differently and the metrics and data points they will use for their research will vary. The goals of the participants themselves play a very important role in the research and this influences the results dramatically. Some factors that could cause a person’s point of view to affect their calculation of fair value include:
- Reason for asset acquisition – Different reasons will carry different measures of urgency and the stronger the urgency to buy, the greater the flexibility allowed in setting boundaries for valuation factors.
- Valuation strategy used – There are different valuation models for different investing styles. A growth investing model looks for stocks at the early stage in the business life cycle. These stocks are likely to experience exponential future growth. A value investing model looks for established companies that are trading below their true value.
How to determine fair value
We calculate a stock’s fair value using the company’s financial statements and, sometimes, econometric models. The fair value shows the company’s actual worth in Naira. An investor should investigate the company’s background to determine the fair value of the company whose stock he intends to buy. We can find information about companies online in their public financial statements. It is essential to investigate all the facts before deciding to invest in stocks.
Several methods are available for properly valuing a company and determining what its fair value is. These include:
- Comparative Companies Analysis
- Discounted Cash Flow Analysis
- Proprietary Valuation Models.
If you would like to build your own valuation model, you can try the Investor Hangout stock screener and see whether it improves your research process.
How to anticipate stock price moves
The market price represents how much it will facilitate the trading of the stock. This is the price that’s agreed to by both the buyer and the seller. Demand and supply will affect the price (we covered earlier in this article). If there are lots of willing buyers and few willing sellers, this will cause the stock price to increase. Likewise, if there are lots of sellers, the price of the stock will drop.
Professional stock investors aim to identify stocks that are trading below their value. If they can find such stocks, they will buy when the price is right and then sell later to make a profit.
Recall from an earlier paragraph that the market operates as an auction and an understanding of the current market sentiment is a guide to determine short-term price ranges and potential movements.
A popular tool for analyzing the price of stocks is Technical Analysis. Technical analysis is a research method that involves the use of financial charts to study the changes in stock prices and volumes.
Understanding that the market is an auction, Technical Analysts believe that you can understand the sentiment of the entire market by viewing price and volume charts. Technical Analysts, ultimately, try to study crowd behavior and try to identify price levels showing:
- Excessive optimism
- Excessive pessimism
Technical Analysis chart of GTBank Nigeria.
Which is more important? Stock price or fair value?
A stock’s price heavily depends on factors such as demand and supply, which can fluctuate widely. The stock’s fair value does not depend on forces of supply and demand. Instead, it depends on the actual value of the asset. It is, therefore, important to look at both the stock price and its fair value, in context.
Sometimes, the stock price moves irrationally as it has more to do with the price that buyers will pay, the supply or demand of the stock, and potential algorithmic function or malfunction. The fair value shows what the stock is worth from an individual point of view (the view of the person who calculated it) and the price shows what the entire market thinks it is worth, right now.
If a business’s cost of capital falls, the price of its stocks would rise because investors expect this reduced cost of doing business to produce higher profits. If there is a dramatic increase in the cost of capital, this is likely to put a strain on the company’s profitability and, ultimately, its stock price. Different parties that have the intention to buy or sell the stocks can interpret these scenarios in various ways. The market, as a facilitator of trade, will, therefore, enable the interaction of both buying and selling parties to agree on what is a fair price for a stock, today.