How to calculate the fair value of a stock

Ask ten investors what a company is worth and you will get ten numbers. That is not a failure of the method — it is the method working correctly. Fair value is not a property of a business the way revenue is. It is a conclusion that follows from assumptions, and different assumptions produce different conclusions.

What separates a useful valuation from a guess is not precision. It is knowing exactly which assumption your answer rests on, and how much the answer moves when that assumption is wrong.

The four inputs that decide the answer

Strip away the spreadsheet and almost every valuation reduces to four questions. Everything else is arithmetic.

1. 1How fast will revenue grow, and for how long?
2. 2What share of that revenue becomes profit and free cash flow?
3. 3What will the market pay for those earnings when you sell?
4. 4What annual return do you require to take the risk?

The fourth question is the one most people skip, and it is the one that does the most work. It is not a prediction about the company. It is a statement about you — the return below which you would rather do something else with the money. Raise it and the price you are willing to pay falls immediately.

Working through the arithmetic

Take a business with $100 million in revenue growing at 8% a year. Over ten years, revenue compounds to roughly $216 million. If the company converts 15% of revenue into free cash flow, that is about $32 million of cash in year ten.

Now choose an exit multiple. At 18 times free cash flow, the business is worth around $583 million in year ten. That is the future value. To convert it into a price you would pay today, discount it at the return you require: at 12% a year, $583 million ten years out is worth about $188 million now.

Divide by the share count and you have a fair value per share. If the market is asking less than that, the difference is your margin of safety.

Run three cases, not one

A single fair value invites false confidence. The same model run three times — conservative, in line with history, and optimistic — produces a range, and the range is the honest output.

If the market price sits below the low case, every version of the future you considered says the shares are cheap. If it sits above the high case, none of them justify the price. And if it sits in the middle — which is most of the time — the honest answer is that it depends on which case you believe, and you should say so.

Where valuations go wrong

• Extrapolating a recent growth spurt for a full decade. Very few businesses compound above 15% for ten years, and the ones that do are rarely cheap.
• Assuming today's multiple persists. A company trading at 40 times earnings today is unlikely to still be there in year ten, and assuming otherwise smuggles the conclusion into the inputs.
• Using a discount rate that is really a hope. If you require 8% because that makes the number work, you have not valued the business — you have reverse-engineered a justification.
• Ignoring the share count. Growing profit alongside a growing share count means profit per share grows more slowly than the headline suggests.

Turn it around: what does the price assume?

The most useful version of this exercise runs backwards. Instead of asking what a business is worth, hold the current price fixed and solve for the growth rate that would justify it. If the answer is 20% a year for a decade in a mature industry, you have learned something the forward model would have buried.

That is the question the analyzer is built around: not what is this worth, but what would have to be true.