What it is:
How it works/Example:
Let's assume Company XYZ stock currently sells for $20 per share. Company XYZ just introduced a new product line, redesigned its packaging, and hired some new managers away from a competitor. Although these changes do not directly appear on the company's financial statements, they may improve Company XYZ's competitive advantage in key markets. For these reasons, investors may assume a stock's future cash flows will be much higher going forward. They could then take their estimated growth rate and calculate the fair value of the stock at $50 per share, or $30 more than what it is currently selling for.
There is no one fair value for a stock at any given time; they vary by investor. An investor's required margin of safety, which is a percentage equal to the amount a stock's price is below its fair value, determines what stock price is attractive to that investor. In the above example, if the investor's required margin of safety is 50%, the investor would only consider purchasing the stock if it traded at $25 or less.
Columbia professor Benjamin Graham, who is credited with conceiving the margin of safety concept in 1934, introduced the idea that a stock's fair value could be methodically calculated. Graham demonstrated that this could be done by analyzing a company's assets and earnings and forecasting its future earnings. However, there are many ways to do this, and virtually all methods of calculating fair value involve making predictions that may not be correct or are influenced by unexpected factors.
Why it matters:
The question of what a security is really worth is one of the basic subjects in investing. By calculating a fair value, investors are able to answer this question in some form, although it may not be precise. Nevertheless, fair value estimates are key to any investor's repertoire.
Approaches to fair value can distinguish value investors from growth investors. Although growth investors aggressively rely on earnings estimates that could be wrong, too high, or otherwise unreliable, value investors only buy stocks selling at a discount to their fair value, and then patiently wait for the fair value of their investments to be realized. Even though both types of investors must face the prospect that their companies may falter, mature, or get so big that maintaining historical growth rates is impossible, most value investors buy stocks with the expectation that the stock price will rise to match the fair value of the company.