HT: How Fair Value and Target Price Differ - Morningstar - Ask the Analyst Shared via AddThis
We are passionate about value investing at Rapidan's Berk Advisory, where we manage separately managed accounts for our clients. We provide comprehensive, institutional level investment portfolios of stocks - not funds - but direct ownership of stocks of great companies. These services have not been generally available to individual investors with small amounts to invest. We've opened up the investment secrets of the very wealthy and made them available to everyone for low fees.
Our pledge to be passionate about long-term performance demands that we use an unemotional repeatable investment process. We call that the ValueAligned Investing system - which marries value investing with the EVA framework for measuring how likely companies' managers will make shareholder friendly decisions far into the future.
FAIR VALUE
The cornerstone of any value investing process is an estimate of the intrinsic value of the shares of the companies we own. We call that the "fair value". When share market prices are sufficiently below fair value we buy.
Many confuse "fair value" with the "target price" that Wall Street brokerage houses (also known as the "sell-side") often issue in their research reports.
Our fair value estimate is based on how much we believe the stock is worth, while a target price estimates how much other investors are willing to pay for the stock. We tend to assess stocks much differently than Wall Street does.
INTRINSIC VALUE AS LONG-TERM BENCHMARK
To determine reasonable buy and sell prices, we look at a stock's margin of safety. We like to buy when a stock's fair value estimate is considerably more than its market price. This is important because buying when the stock is trading at a discount protects the investor just in case the fair value estimate is too optimistic. On the other hand, when the market price has climbed far above the fair value estimate, this may be an indication that the stock is overvalued and potentially vulnerable to any hiccups that might come along.
To estimate the fair value estimates, we use proprietary EVA, economic margin and discounted cash flow models. All these models assume that the stock'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.
Wall Street target prices are usually developed by taking an earnings estimate and then applying a multiple, most typically a price-to-earnings (P/E) ratio. In theory, the P/E ratio shows how much investors are willing to pay for a firm's earnings. To arrive at a target price for the future, Wall Street analysts multiply an appropriate multiple by their earnings estimates per share to get a target share price.
We emphasize cash flow and economic returns; On the other hand, Wall Street analysts emphasize accounting earnings. What's the difference? Management has much more discretion over accounting earnings and we think smart analysts should make a number of adjustments to make company results look more like economic earnings.
Also, another difference is that we have a much longer time frame when thinking about a company's future economic return. This is called the Competitive Advantage Period and given our analysis of management, strategy and competitive position we estimate how long a company will be able to earn economic returns above its cost of capital.
Target prices from Wall Street analysts apply to short-term time periods and often contribute to the prevailing emotions over a particular stock. With a shorter time-frame, sell-side target prices focus on the company's ability to meet short-term forecasts for the next quarter and year.
As long as we have an idea of what a stock is worth, we are in a better position to determine whether it's at buy below price or at sell above price.
Benjamin Graham said that in the short run, the stock market is like a voting machine-tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine-assessing the substance of the company. Target prices are meant to appeal to the voters while our fair values are meant to be unemotional assessments of value.
BERK
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