Is It Fair to Value Stocks at Fair Value? Part 1
July 13, 2010
More importantly for investors, is this valuation just a trapdoor to high risk? Fair Value gives the value of a company now based on future earnings. Unlike PER, PBV or PCF, computing fair value has a long process. It starts with computing the Capital Asset Pricing Model (CAPM). It is the Risk Free Rate plus Risk Premium times the company’s Beta. Risk Premium is Market Rate minus Risk Free Rate. There are a lot of assumptions to use in computing CAPM, and below are some samples.
The Risk Free Rate are rates from sovereign debt, debt that is sure to be paid by the government. The Market Rate is the return from stocks and bonds (company debts). The return from stocks is volatile especially in the last three years from the effects of the global financial crisis. In computing CAPM, one can use a Risk Free Rate as low as 4.49%, for example, to a high of 8.7%. The same goes with the Market Rate.
The company’s Beta is the slope between the company’s share price movements along with the PSEi. For our discussion’s case, we will use Jollibee Foods Corp. (JFC) as our sample company. One can choose a time span for Beta to use for CAPM spanning one year, for example, year to date or half a year. With the chosen assumptions, one can already compute CAPM. Based on a year to date Beta and our sample rates, one can have a CAPM as low as 6.12% to a high of 43.61%. For the high, however, we selected for the table below the year to date PSEi as our Market Rate since the One-Year and Five-Year PSEi growths look like outliers in the set of Market Rates.
On the first part of computing Fair Value, a major problem is already encountered. There is no universal or common assumptions to use, thus computed Fair Values will be highly different from one another. Percentage change-wise, the variance between the two CAPMs we computed alone is huge at 78.7%. In addition, foreign investors computing the fair values of Philippine stocks will most likely use different rates as their CAPM assumptions. This again brings out very different Fair Values. A company promoting a particular stock will also most likely use CAPM assumptions that will bring out a high Fair Value for the stock. This signals big risk for investors just seeking stocks which can give them back the highest return possible for their investment.