Not the Market’s Price, but the Price that Reflects the Value of the Company

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How much should you pay for a share of stock, any stock? This is the most difficult question that investors in the stock market face when trying to decide which stock is at the right place, fits their financial goals and risk tolerance.

If you dive into the subject, you quickly find there are many competing valuation models that will help you arrive at what is called the fair value price. The fair market (or value) price, which is an estimate, represents how much the company is worth based on its economics and financial strength.

This price should not be confused with the daily price posted on the stock market. The daily price is subject to many influences that have nothing to do with the value of the company as an ongoing business.

Yet, you have to buy stock in the stock market, so your challenge is to figure out is the current price a good buy or not. Many investors struggle with coming up with a price that represents what the company is worth.

Valuation models help investors determine a price that is the basis for making a buy decision. It is important to note that many investors do not pay the fair value price, but factor in a discount called the margin of error to provide for the possibility their estimate is wrong.

There are two very broad ways to combat this fair value estimate. The first model is called the intrinsic value and strictly looks at the value of the business, in other words it comes up with a fair value price based on the fundamentals of the company.

The other broad category of valuation models looks set comparing the target company to other similar companies often based on the price earnings ratio (P/E) or some other major metric.

This model is called a relative valuation because it uses similar companies to come up with a value for your target company.

The relative model can be compared to real estate appraisals, which often include the sales of comparable homes in the neighborhood to develop a market price for a house being offered for sale.

The relative valuation model models are usually quicker and easier than determining the intrinsic value or absolute value about or a stock.

Many investors use both models starting with the relative valuation model and moving to the more complicated absolute valuations after they have narrowed down their search eliminating potential companies by the relative valuation model.

Relative model are fairly unique easy to demonstrate, so I will spend some time going through demonstrations of how they work. For this I’m using for real companies and the real numbers associated with the stock. I’m not using the names of the company because this article may stay on the web for some time and much can happen that might change the outcome of these relative valuations over time.

Below are the four companies that I will use in this demonstration. Company four is the target company that I will be considering for investment. The other three companies are in the same industrial sector and approximately the same size as our target company. I will use the same 3 companies for other demonstrations in the future. The companies: