FIREDesk
Full guide · 8 min read
How to value a stock yourself: earnings, fair price and margin of safety
The method I use on my own stock list, step by step, with a worked example and a calculator you can try with your own numbers. It will not tell you what to buy. It will teach you to ask the right question: what do I think this business is worth, and how wrong could I be?
1Price is not value
The price is what the market pays today. The value is what you think the business is worth, given what it earns and how fast it may grow. They are often different, sometimes for years, and the gap between them is the only place a stock investor can find an edge.
I kept a spreadsheet for each stock I follow for years: what it earns, what I expect, what P/E is fair, and what price that implies. The method below is that spreadsheet, cleaned up. I update the figures as companies report real results, and I mark which numbers are real and which are my estimates.
2Step 1: earnings per share
Earnings per share (EPS) is the profit of the company divided by the number of shares. To estimate it, start from three numbers you can find in a company's investor relations material:
- Revenue (sales) for the year.
- Net margin: net income divided by revenue.
- Diluted shares: the number of shares counting options and convertibles.
EPS = revenue x net margin / diluted shares. Keep the real numbers (reported) apart from the estimates (your forecast), so you can see later how good your forecasts were.
3Step 2: choose a fair P/E
The P/E is the price divided by the EPS. A "fair P/E" is the multiple you believe the market should pay for this business over time. It is the most important and the most subjective number in the whole method, and the one beginners get wrong.
Things that push a fair P/E up or down:
- Growth. Faster and more reliable earnings growth justifies a higher P/E.
- Type of business. Banks, mature businesses, cyclical businesses and fast-growing ones trade on different typical multiples. Look at the history of the stock and of its peers, not at one number.
- Quality and risk. Debt, how stable the profits are, and how much depends on one product or one customer.
- Interest rates. When safe yields are higher, investors usually pay lower multiples.
4Step 3: fair value and upside
- Fair value per share = EPS x fair P/E. You can compute it for this year and for each of the next five, using your estimates of EPS.
- Upside to year N = (fair value in year N - today's price) / today's price.
- Express it per year as well: a 60% upside in five years is about 10% a year, which is easier to compare with other choices.
Treat the later years with more suspicion: errors compound. A forecast for year 5 is a range, not a number.
5Step 4: margin of safety
Because you can be wrong, many value investors only act when the price is below their own fair value by a cushion. In my own work I look for the price to be about 10% to 20% below my fair value. I treat a 10% discount as "undervalued" and 20% or more as "deeply undervalued", and a price 10% or more above fair value as "overvalued". Those thresholds are mine; you can choose different ones, but choose them before you look at the result.
How much to put in a stock is a different question that no formula answers for everyone: it depends on your total assets, on how diversified you want to be and on the cash you may need.
6Cross-checks: PEG, debt, dividends, trend
- PEG = P/E divided by the yearly earnings growth in percent. A common rule of thumb treats about 1 as fair and much higher as demanding. If your fair P/E gives a high PEG, ask whether it is too generous.
- Debt and cash: a business with heavy debt can look cheap and still be fragile.
- Dividends: a payout is part of the return, but check it is paid from earnings and not from borrowing. Taxes on dividends differ by country.
- Trend: some investors also look at where the price sits against its 200-day average to avoid buying something that keeps falling. It is a filter, not part of the valuation.
- Currency: value each stock in the currency of its listing.
7A worked example (a made-up company)
Example Corp is invented for this guide. All figures are illustrative.
| Input | Value |
|---|---|
| Revenue this year | $10,000 million |
| Net margin (kept constant) | 10% |
| Net income | $1,000 million |
| Diluted shares (kept constant) | 500 million |
| EPS this year | $2.00 |
| Expected revenue growth | 8% a year |
| Fair P/E (mature business, history of 12 to 18) | 15 |
| Share price today | $27 |
| Result | Value |
|---|---|
| Fair value today: $2.00 x 15 | $30.00 |
| Price vs fair value today | 10% below |
| EPS in 5 years (revenue x 1.08^5, same margin and shares) | $2.94 |
| Fair value in 5 years: $2.94 x 15 | $44.08 |
| Upside to year 5 | +63% |
| Per year | about 10% |
| PEG: 15 / 8 | 1.9 |
8Try it: the calculator
Enter your own assumptions. The result is only as good as the numbers you put in.
A model result against your own assumptions, not a recommendation to buy or sell. Nothing is stored or sent.
9Mistakes, and how to keep a record
- An optimistic fair P/E. Raising the multiple makes everything look cheap. Anchor it to history and peers.
- Extrapolating a good year. Cyclical profits at a peak are not a normal year.
- Falling in love with a stock. If the facts change, change the number.
- Ignoring debt, dilution and one-off items in the profit.
- Concentration. One stock with a lot of money is a bet, not a method.
- Not keeping a record. Write the date, the price, your fair value and the reason. When you change an assumption, write that down too. After a year your own log becomes the best teacher: you will see which assumptions were wrong.
A one-page checklist for every stock
- I have the real revenue, margin and diluted shares, and I know which numbers are my estimates.
- I chose a fair P/E and wrote the reason in one line.
- I computed fair value today and in year 5, and the upside per year.
- I know how far the price is below or above my fair value, and my threshold was fixed in advance.
- I checked PEG, debt, dividend coverage and the currency.
- I decided how much this could be of my total assets, and I can live with losing it.
- I wrote the date, the price and my reasons in my log.
Next step
You have seen the method. With Stock Eval you see where each stock's price stands against the model, what the price implies and what happens if you change the assumptions. It is in beta: request access.
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Legal. FIREDesk content is for educational purposes only and is not financial advice or an investment recommendation. FIREDesk does not give personal recommendations and does not know your situation. The company in the example is invented and its figures are illustrative. Valuations depend on assumptions that can be wrong, and past performance does not guarantee future results. Investing involves significant risk, including the loss of the money invested. The author may hold positions in securities he studies; nothing here refers to any specific security. Tax treatment depends on your country. You are responsible for your own decisions. Disclaimer · Privacy