Canadian Dividend 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 subsequent decade of favorable business developments.
1
Warren Buffett
The fair share price is sometimes referred to as the fair share value and is considered to be the inherent (or intrinsic) financial value of the common shares of a company. The fair share price represents the maximum price you should pay for the shares, based on their expected financial return. Ideally, you should only buy the shares of a company when the market price is lower than the fair share price. The greater the discount from the fair share price, the greater the factor of safety against overpaying.
The fair share price of every company is necessarily 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 share price for common shares, in my opinion, the most useful approach is based on the axiom that the fair price of any asset is equal to the price that buyers have been 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, the most common approach is to use the price to earnings (P/E) ratio when comparing the financial value of shares with respect to their historical P/E ratios, or with respect to the historical P/E ratios of their peers. 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 provides historic data on both the prices and the annual earnings for the companies included in their coverage universe. For example, the highest and lowest prices and annual earnings are highlighted on the following image, which was copied from the Value Line report for Sun Life Financial services, dated May 3, 2024:
The highlighted data has been copied in the following table. The highest and lowest price to earnings (P/E) ratios were then calculated for each year using the respective values, and the results are presented in bottom 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 Value Line 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 share price for the shares in 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 share price of $86. Of course, unforeseen 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 share price of $86.
Finally, you should note that, as we have seen, there is considerable room for judgement in the choice of the values used in these 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.