It’s important to buy an investment at the right price, which means buying it at its fair value. But how do you calculate a stock’s fair value? In this episode of “The Morning Show” on Motley Fool Live, recorded on Dec. 21, Motley Fool Senior Analyst John Rotonti gives you a quick key to figuring it out.
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John Rotonti: Another definition of fair value — and Maria, we’ll move on after this — but we’ve used the phrasing intrinsic value and fair value a lot this morning as we talked about discounted cash flows and reverse DCFs. They mean the same thing. There’s two ways to think about what is intrinsic value and what is fair value. One way is what we said. It’s the present value of future free cash flow. That’s one way to think about intrinsic value or fair value. The other way, and maybe a way that is easier for some people to grasp because we all learn in different ways, is fair value. This is really important. You want to write this down, Fools. Fair value is the price you can pay — [laughs] Jim, you know this, you don’t need to write down. Fair value is the price you can pay and generate your required rate of return if your model is in the right ballpark, if your model is correct. Fair value is the price you can pay and expect to generate your required rate of return in that stock. If you calculate fair value to be $100 and you used a 12 percent discount rate, if you calculated fair value to be $100 and you used a 12 percent discount rate, then buying the stock at $100 means you should expect — we’ll be exact, and it won’t happen every year — but over the long term, you should expect to generate a 12 percent return on that stock investment. Rough. That’s what fair value is, the price that you can pay and expect to generate your required rate of return. Two different ways to think about fair value.
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