How to calculate the fair value of a stock – step by step
The fair value of a stock is the sum of all the money the company will have left over in the future – translated into today’s money. You need three ingredients: free cash flow, an assumption about growth and an interest rate for discounting. If the share price is well below that value, you have a cushion for mistakes in your assumptions.
Price and value are not the same thing
A stock’s price is what other people are paying for it right now. It rises when everyone is talking about a company and falls when fear takes over. A company’s value changes much more slowly. It depends on how much money the business earns over the years.
This distinction is at the heart of Benjamin Graham, Peter Lynch and Warren Buffett. If you know the value, you don’t have to get nervous at every move in the price. You know whether you are paying too much or looking at a good deal.
The three ingredients
The best-known method for estimating value is called discounted cash flow, or DCF for short. It rests on three questions. The answers are assumptions. That is why fair value is never an exact number, but a well-reasoned estimate.
Free cash flow is the money a company has left after it has paid all its bills and invested in its future – in machines, buildings, software. It is more honest than profit, because accounting tricks are hard to hide in it. In the end, what counts is what actually lands in the bank account. More on this in the article Free cash flow.
Growth describes how that amount develops. The usual approach splits it in two: a few years of higher growth, followed by a permanently lower rate, roughly in line with the growth of the economy as a whole.
Discounting is the idea that money today is worth more than money tomorrow. €100 in five years is worth less than €100 today, because in the meantime you could have a safe alternative and because the future is uncertain. The rate you discount with expresses exactly that: the more uncertain the company, the higher the rate. More on this in the article Discounting.
The formula
Put together, it looks like this. Don’t worry: the formula just says in symbols what is written above in words.
- FV
- fair value (per share)
- FCFt
- free cash flow in year t
- r
- discount rate, for example 9% = 0.09
- n
- number of years you plan individually
- TV
- terminal value: all years after year n combined
The first part brings each planned year back to today, one by one. The second part, the terminal value, combines all the years after that. For this, you assume that from then on the cash flow grows steadily every year at the rate g:
- g
- long-term growth after year n, for example 2.5% = 0.025
Important: g must be smaller than r. Otherwise the formula would produce an infinite value – and no company is worth an infinite amount.
The worked example
Let’s take a made-up company, Example Inc. Today it generates €10 of free cash flow per share. We assume it grows by 8% a year for five years and by 2.5% a year after that. We discount at 9%.
| Year | Free cash flow | Value today |
|---|---|---|
| 1 | €10.80 | €9.91 |
| 2 | €11.66 | €9.82 |
| 3 | €12.60 | €9.73 |
| 4 | €13.60 | €9.64 |
| 5 | €14.69 | €9.55 |
| Sum of years 1–5 | €48.64 | |
| Terminal value (all later years) | €231.70 | €150.59 |
| Fair value per share | €199.23 |
How to read the table: in the first year, cash flow grows from €10 to €10.80. But because you only receive the money in a year’s time, it is worth just €10.80 ÷ 1.09 = €9.91 today. In year five it is €14.69, worth only €9.55 today – the further away, the more it is discounted.
For the terminal value, the cash flow from year 5 grows by another 2.5% and is then divided by 9% − 2.5% = 6.5%: €14.69 × 1.025 ÷ 0.065 = €231.70. Discounted back to today, €150.59 of that remains.
What stands out: a good three quarters of the fair value sits in the terminal value, in everything after year five. That is exactly why the result reacts so strongly to the long-term growth assumption. More on that below, under common mistakes.
The margin of safety
Benjamin Graham, Warren Buffett’s teacher, coined a term for this that still holds today: the margin of safety. Because your assumptions will never be exactly right, you don’t buy at fair value but at a distance below it.
With a margin of safety of 25%, that would mean for Example Inc.: fair value €199.23 × 0.75 = about €149. If the price is above that, you wait. If it is below, you have a cushion in case the future turns out worse than expected. How big that cushion should be is up to you – the more uncertain the company, the bigger. More on this in the article The margin of safety.
Why one model is not enough
The DCF is honest, but sensitive. Small changes to the assumptions move the result a lot. That is why a second and third angle pays off – for example a comparison based on multiples such as EV/EBITDA, where you look at how the market values similar companies. If the results are far apart, that is not an error but a hint: one of your assumptions is too optimistic or too cautious.
And not every company can be valued this way. For a bank, lending money is the actual business, so free cash flow says little there. For a REIT, a real estate company, depreciation distorts profit. Both need their own models.
Three common mistakes
This calculation for any stock – in seconds.
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Frequently asked questions
Which discount rate is right?
There is no single right one. For large, stable companies, around 8 to 10% is common; for younger or riskier ones, more. What matters is that you choose it deliberately and follow the same logic for every stock.
How many years should I plan individually?
Usually five to ten. The further into the future you plan, the more uncertain the numbers become. Five years is a good start; after that, the terminal value takes over.
Does this work for banks and REITs?
Only poorly. For banks, lending money is the business; for REITs, depreciation distorts profit. Both have their own valuation models, for example based on book value or on funds from operations (FFO).
Is fair value a buy recommendation?
No. It is the result of your assumptions. Whether you buy is your decision – fair value just helps you not to buy blindly.
Not investment advice. All content is for informational and educational purposes only. Example Inc. is made up; real companies are mentioned only as examples, not recommendations.