Why the Fair Value Estimate Is a Big Freaking Deal
High and low are meaningless without a reference point.
You wouldn’t buy a car without knowing its Blue Book value. You wouldn’t buy a house without an appraisal. Why would you buy shares in a company without knowing the fair value? Morningstar’s Fair Value Estimate is a smart shortcut that can help you find great companies at bargain prices and avoid getting trampled by the investing herd.
Following the Herd Can Lead to Ruin
Investors can act like buffalo that follow one another somewhat blindly. For instance, a rumor starts that XYZ company is going to be the next Google (GOOG) or Amazon (AMZN) and people start buying. As demand drives the price upward, the forecasts appear to be correct, and the herd starts a buying frenzy trying to get in before the peak. What we call a market “bubble” is when this race-to-buy pushes the price significantly higher than the stock is actually worth, until no one is willing to buy at the inflated price. At that point, someone starts selling at a slightly lower value so as to cash in at the peak. Bubble: burst. As the price drops, the herd panics, starting a selling frenzy that sends the price of the asset into the proverbial toilet. Behavioral finance folks call this “herd behavior” for obvious reasons.
We’ve seen this play out time and time again. During Tulip Mania in the 17th century, one tulip bulb sold for more than 10 times the average worker’s annual salary. In what Douglas-Adams-inspired universe is that reasonable? Ours, apparently.
In the 1840s, Railway Mania broke out in the United Kingdom and many middle-class families lost their life savings when it became clear that the market had been overhyped. More recently, the dotcom bubble sent investors into bankruptcy when the first generation of Internet giants hit the rocks (Cisco (CSCO) lost 86%, for example) and others failed completely.
Then, of course, there was 2008, when the housing market grew out of control and then crashed suddenly. I watched as family members invested in properties in the Phoenix area, hoping they would find another investor to buy them out within a few years. However, by the end of the real estate boom, it was just investors buying from one another without the demand for actual residents in the homes. Speculator sold to speculator until one poor sot was left holding the house-shaped bag.
In every case a few people grew very rich, but many, many more lost everything. Not knowing the true value of something leaves you vulnerable to this kind of catastrophic event.
Countering the Herd Can Also Fail
Because the herd is often wrong, some people adopt a contrarian rule of thumb. As Warren Buffett famously said, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
This contrarian viewpoint has its merits, but without a reference price for comparison, contrarianism is equally unreasonable. Countering the herd’s behavior or trying to predict what the herd will do next is still investing based on emotional guesswork, not fundamental analysis.
In fact, Buffett’s statement above doesn’t mean that you should just watch the herd and do the opposite. Rather, it means that when the herd has abandoned a quality company out of fear, you can take advantage of the fact that they have driven down the price and invest while it’s effectively “on sale.” Another famous Buffett quote sums this up as, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it’s marked down.”
Put differently, to make a good stock pick, you need to 1) know that a company’s fundamental value is solid, and 2) buy it when the market price is fair, or better, when it is selling at a discount. To do this you need to have a fair value estimate.
Focusing on the Fair Value Estimate Helps
The fair value estimate is a smart shortcut that can help you determine whether the price of a stock is high or low compared with its fundamental value--not hype, not fear. Calculating the fair value estimate involves looking at a company’s financial statements and annual reports, and assessing the management structure, competitive advantage, and corporate governance. It estimates the future cash flows of the company and adjusts them to today’s dollars. Based on that research, a value is calculated that estimates the value of the company and what one share of stock should sell for if no emotions or headlines or hype from talking heads were involved. Fundamental analysis is not perfect. It is an estimate, and there are uncertainties involved for sure, but it is a much more reasonable estimate of the long-term fair value of a stock than “Whatever people are willing to buy it for today.”
You may not have the time, knowledge, or interest to dig deeply into fundamental analysis and calculate the fair value estimate yourself. Morningstar’s analysts develop fair value estimates for thousands of companies based on independent, unbiased fundamental analysis. Our analysts are assigned to particular companies and they research those companies deeply, follow them for years, and do their best to keep an accurate and up-to-date fair value estimate for a share of that company. Morningstar was founded for the express purpose of making this kind of information available to the general public so that everyone could make informed investment decisions.
The Smart Shortcut
The fair value estimate provides necessary context to help you survive the herd’s stampedes. Without a logic-based reference point, “low” and “high” are meaningless, but if you know the fair value estimate, then you can buy when the herd’s price is low--relative to the fair value estimate--or sell when it’s high.
While the fair value estimate is just one of several data points you may want to consider, it is a start, and it beats focusing on herd behavior or cable news hype. In future articles, I’ll talk more about some of the other metrics that can help you be a more rational investor, but for now remember this: Whatever the herd may do, remind yourself that the fair value estimate is a big freaking deal.
Sarah Newcomb does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.