Fair value

There have been a lot of talks recently about the "fair value" concept (which is as old as the first coin).
In 2006, I wrote a paper on stock market indexes entitled: The Profitip Index (registered name: Leclere® index). To summarize it, the idea is to try to anchor a national stock market index to the nominal GDP growth rate of a country: a sort of "nominal GDP targeting" stock market index.
From the onset, I realized that the major problem with the proposal made in the paper was to find the right equilibrium price to be used as the starting base/reference for the index.
The actuality made me take the paper from the shelve, have a fresh look at it and try to come up with a new proposal.

Proposition:

At the equilibrium:
1/ 1 $ invested in the stock market (i.e. in the capital of a company) delivers a return ( "% (earnings minus dividend)/$ share") (A) equal to the nominal GDP growth rate.
2/ Nominal GDP growth rate = average interest rate, which is then said to be the "equilibrium interest rate" (B).
3/ Equity risk premium = dividend yield.
4/ Fair value = (B) - (A) = 0
Interpretation: the fair value is the relative value of stocks compared to bonds. If the fair value is above(below) zero and the dividend yield is not taken into account, bonds have a better(worse) return than stocks.
5/ Potential relative return of stocks v. bonds = fair value + dividend yield

The proposition is made at the macro level and is not meant to be used on an individual company level.
It can be applied to compare different countries.

Example: (end-of-February 2008 - data sources: The Economist and Standard&Poor's)


(Click on image for a better view)

(*) tentative equilibrium: the equilibrium is thought to be targeted when the average lending rate is close to the nominal GDP growth rate (difference < +/- 1%).

One should also add other criteria like: earnings/$ share, growth rate, inflation, budget balance, current account balance, average lending rate, price to cash flow, price to sales, to name but a few.

Important notice: these data have to be regularly updated. They are provided as an illustration of a method and are not recommendations to buy or sell any equity. Market timing is important in investing.

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