Canadian Focus Investors
1
Estimate the Fair Share Price
For the investor, a too-high purchase price for the stock of an excellent company
can undo the effects of a subsequaent decade of favorable business developments.
1
Warren Buffett
The financial value of the common shares of a company is also referred to as the fair value or fair price, and represents the maximum price you should pay for the shares, based on their expected financial return. Ideally, you should only buy the shares when the market price is lower than the fair price. The greater the discount from the fair price, the greater the factor of safety against overpaying.
The fair share price of any company is somewhat subjective, because it depends on other investors' expectations with respect to the company's future financial success. While there are several different methods for estimating the fair price of common shares, in my opinion, the most useful approach is based on the axiom that the fair price of anything is equal to the price that buyers are willing to pay, whether it be for a house, a used car, or the common shares of a public company.
The financial value of a common share depends in part, on the company's earnings per share. While it is true that many other factors, besides earnings, affect share prices, it is conventional practice to use the price to earnings (P/E) ratio when comparing the financial value of shares with their historical values or among different companies. In particular, it is helpful to know the range in P/E ratios that a company's shares have experienced in the past, since this can provide a reasonably good indication of the range in P/E ratios that can be expected in the future.
Conveniently, Value Line Investment Services (VLIS) provides historic data on both the prices and the annual earnings for the companies included in their coverage universe. For example, the prices and annual earnings are shown, as indicated, on the following extract from the VLIS report for Sun Life Financial services, dated May 3, 2024:
The highest and lowest price investors paid per share of Sun Life Financial (SLF) each year from 2013 up to May, 2024 are highlighted near the top of the report, as indicated above. This share price data, along with the annual earnings per share have been copied in the following table. The highest and lowest price to earnings ratios were calculated for each year using the respective values, and the results are presented in last two lines of the table.
As shown, the highest P/E ratios in recent years (2019 to the end of 2023) ranged from 10.7 (in 2021) to 16.2 (in 2020). Based on these values, it is reasonable to expect that the highest probable P/E ratio that can be expected to the end of 2024 will be about 15. Since the VLIS analyst expects that SLF's earnings to the end of 2024 will be $6.85, it can be expected that the maximum price for the shares to the end of 2024 will be about $103 (15 x $6.84).
Similarly, the lowest P/E ratios in recent years (2019 to the end of 2023) ranged from 8.3 (in 2021) to 11.4 (in 2023). Based on these values, it is reasonable to expect that the lowest probable P/E ratio that can be expected to the end of 2024 will be about 10. if the earnings to the end of 2024 are $6.85, then the lowest price for the shares to the end of 2024 would be about $69 (10 x $6.84).The estimated average or fair price for the shares to the end of 2024 is therefore calculated to be $86 [($69 + $103) / 2 ].
In summary, by the end of 2024, the market price for a common share of SLF can be expected to fall somewhere between $69 and $103, with an estimated average or fair price of $86. Of course, unforseen events could occur that could have a positive or negative effect on SLF's business, so that the share price may fall outside the expected range before the end of 2024. Nevertheless, based on the foregoing analysis, I would consider buying the shares anytime the price falls significantly lower than the fair value of $86.
Finally, you should note that, as we have seen, there is considerable room for judgement in the choice of the values used for the calculations. For this reason, you should always check your results with those of other trustworthy sources. There are good reasons why it is called the art, not the science, of investing.
1. Attributed to Warren Buffett. Source unknown.