When you look at the analysis page for a particular company, in most cases you will see fair value for the company’s stock in the Valuation section. There are many methods which can be used to determine the fair value of a company, but the Simply Wall St app uses discounted cash flow analysis (DCF) to calculate the fair value shown on the app.
DCF is the most widely accepted method to calculate the fair value of a company. It is based on the premise that the fair value of a company is the total value of its future free cash flows (FCF) discounted back to today's prices. FCF is the company’s incoming cash flows less its cash expenses. It represents the cash available for the company to distribute to shareholders in the company or pay back the company’s creditors.
Why calculate the company’s fair value?
While the stock market sets a "price" for a company, this price will often be affected by a wide range of factors. Some of these factors may not impact the true worth, or fair value, of the company. By comparing the market price to the fair value of a company or a set of companies or indices, investors can determine whether a company's shares are potentially overvalued or undervalued.
Which DCF method is used to calculate fair value?
Simply Wall St uses 4 variations of DCF depending on the characteristics of a particular stock, such as its industry and data availability for the company.
- 2-Stage Discounted Cash Flow Model
Suitable for companies that are not expected to grow at a constant rate over time. These companies tend to be high-growth initially and become stable after a couple of years.
- Dividend Discount Model (DDM)
Suitable for companies that consistently pay out a meaningful portion of their earnings as dividends.
- Excess Returns Model
Used for financial companies such as banks and insurance firms. These companies generally do not have a significant proportion of physical assets and face different regulatory requirements for cash holdings to other businesses.
- Adjusted-Funds-From-Operations (AFFO) 2-Stage Discounted Cash Flow Model
Used for Real Estate Investment Trusts (REITs) as these companies incur capital gains and other real estate-specific factors which impacts their free cash flows.
Tip: You are able to view all of the inputs, formulas and the DCF method that has been used for a particular fair value calculation by selecting the “View Data” button under the fair value infographic.
For more information about our DCF analysis and each of the 4 methods used, read more on our Github page.
Fair value vs share price is NOT a buy or sell recommendation
While we do provide an estimate of fair value for many companies, their fair value discount or premium to the current share price should NOT be used in isolation to make investment decisions.
There are many assumptions made when estimating a company’s fair value and a large number of inputs go into the calculation. Although every effort is made to ensure the assumptions are reflective of the company’s future prospects, it is impossible to predict the future with complete accuracy. Even a small change to some of the inputs in a DCF calculation can cause a large change in the fair value estimate.
Investors should therefore simply consider the estimated fair value as one of many considerations that go into making an investment decision. They still need to take their own investment objectives and risk appetite into consideration. Our aim is to provide high-quality analysis based on the data we have available for any company. We want to empower you with information that can allow you to make informed decisions on your investments.