How is Fair Value Determined?

Power Integrations, Inc.

One of the most important investment principles is to buy great companies at a good price. Finding great businesses is the easy part, but how do you know if its stock is overvalued or undervalued? The Roen Financial Report calculates “Fair Value” for each of the +/- 250 companies it tracks so that you can know if a stock is cheap or expensive.

Fair value is a measure of where a stock’s current trading price is in relation to what we believe a fair price is for that stock. If a stock looks cheap, a fair value meter for that company will show it as undervalued on its Company Profile page. Conversely if a stock looks expensive, the fair value meter will warn readers with an overvalued signal. (to see a sample company profile click here).

Calculating Fair Value

What is the best way to determine fair value? It is a question many analysts ask, and different forecasters use different methods. Some favor looking at what a company has done in the recent past, so they look at “trailing” earnings. Others are more interested in determining a company’s projected earnings for the next few quarters or years, so they use “forward” earnings. Here at the Roen Financial Report we prefer to use a balance of forward, trailing, and current earnings as expressed in a company’s price to earnings ratio (P/E) and earnings per share (EPS) to get the truest picture of what a company’s fair value should be.

For example, Power Integrations (POWI) has performed well since it was entered into the Paradigm Portfolio in May 2009. At the end of March 2012, however, it still looked like a good value. The math below explains why this was so for POWI.

Fair Value Calculation

When you average a combination of the EPS at that time, three years of trailing EPS and three years of projected EPS, it comes out to 1.44. The bottom of the fair price range was determined by taking the median of annual P/E lows for the past three years (20.48), and multiplying it by the average EPS determined above (1.44) to get a low fair price of 29.49. The top of the fair price range was similarly calculated by using the median of annual PE highs for the past three years (37.17) multiplied by the average EPS (1.44) to get a high fair price range of 53.52.

The stock price at that time, 37.12, was shown as a percentage of where it fell in the fair price range. This value was categorized in the following manner:

80-100% of fair price range or over top fair price = Overvalued

60-80% of fair price range = Above fair value

40-60% of fair price range = Fair value

20-40% of fair price range = Below fair value

0-20% of fair price range or below bottom fair price = Undervalued

Fair Value Chart

When Fair Value is graphed over time, it gives a good indication of how a company’s stock price has changed in relation to valuation. Below is an example of the interactive Fair Value graph for the Swiss smart grid company ABB Ltd. ADR (ABB). The dark blue line shows the weekly closing stock price, and the shaded area is our estimate of the fair value range for the company. As can be seen below, this information is very useful for investors.

For example, the chart shows that after July 2011 (when the ABB was considered above fair value to overvalued for four months), the stock dropped 39% over the next 3 months. Conversely, when ABB reached undervalued levels in both the second half of 2011, and thru spring of 2012, investors would have done well to buy when it was trading in the $16 – $17/share range. Since the beginning of 2013, the stock has jumped back into the overvalued range, so holders of the stock may want to reconsider their position.

Company Profiles With No Fair Value

If there is not enough earnings data to calculate fair value for a company, the Fair Value Meter will indicate “Not Enough Data” and the Fair Value Chart will not appear on the company profile.

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