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The Predictive Power of Fair Value Estimates

Investors would be smart to focus on stocks that trade at a discount to this metric.

James X. Xiong and Thomas Idzorek and Warren Miller, 10/14/2013

This article originally appeared in the October/November 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.  

Shares of discount brokerage Charles Schwab SCHW have been on a roll, rising 76.8% over the past 12 months through July 31. That’s a far cry from where the shares stood in mid-2012. At that time, a share price of $12.50 represented almost a 50% discount to Morningstar’s assessment of their fair value. Investors who realized that discrepancy and stood by the shares have been rewarded for their patience as Schwab has been buoyed in part by its proprietary mutual fund and exchange-traded fund businesses, higher total administration fees, and rosy forecasts that its net interest income could benefit from higher future interest rates.

Morningstar derives a fair value estimate for companies such as Schwab that are on its current coverage list. Our fair value estimates for stocks are proprietary data points that represent our equity analysts’ estimates of what they are worth. The fair value estimate is calculated as the present value of a future stream of cash flows to equity holders discounted to account for the systematic risk of that income. By comparing a fair value estimate to the price of a stock, an investor can determine whether a stock is over- or undervalued.

At Morningstar, our analysts estimate a company’s fair value by determining how much we would pay today for all the streams of excess cash generated by the company in the future. We arrive at this value by forecasting a company’s future financial performance using a detailed discounted cash-flow model that factors in projections for the company’s income statement, balance sheet, and cash-flow statement. The result is an analyst-driven estimate of the stock’s fair value.

But does fair value estimate have the power in predicting future stock returns such as those experienced by Schwab the past year? To find the answer, we investigated all stocks that had received a fair value estimate from January 2002 through March 2013. The results of our study show that investors would be wise to pay attention to discounts to fair values. Stocks that were undervalued based on their fair values outperformed other stocks significantly on a risk-adjusted basis.

Fair (Value) Game
In our dataset, on average, there were about 930 stocks that had fair value estimates in each month over the time period. We sourced monthly returns, monthly ending prices, monthly market caps, and monthly book to market ratios from the Morningstar equity database.

A positive RFV indicates that the stock is undervalued, and a negative RFV indicates that the stock is overvalued.

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