Fair value of a stock is an estimate of what a share is truly worth based on the company’s earnings, cash flows, or assets, independent of its current market price. There’s no single “correct” number, but several well-established methods can get you to a reasonable estimate. The three most widely used approaches are discounted cash flow analysis, relative valuation using multiples like the P/E ratio, and the Graham Number formula. Each works differently and suits different situations, so understanding all three gives you a more complete picture.
Discounted Cash Flow (DCF) Analysis
DCF is considered the gold standard of stock valuation because it estimates what a company is worth based on the actual cash it’s expected to generate in the future. The core idea: a dollar you’ll receive five years from now is worth less than a dollar today, so you “discount” future cash flows back to present value. The sum of all those discounted cash flows is the company’s intrinsic value.
The formula looks like this:
DCF = CF₁ / (1 + r)¹ + CF₂ / (1 + r)² + … + CFₙ / (1 + r)ⁿ
Where CF is the cash flow for each year and r is the discount rate. The process breaks down into three steps:
- Forecast the cash flows. Look at the company’s free cash flow (operating cash flow minus capital expenditures) from recent years, then project it forward, typically five to ten years. You can base your growth assumptions on the company’s historical growth rate, analyst estimates, or industry trends. Be conservative here, since small changes in growth assumptions produce big swings in the final number.
- Choose a discount rate. The discount rate reflects how much return you’d need to justify tying up your money. Many investors use a rate between 8% and 12% for stocks. A common approach is to use the company’s weighted average cost of capital (WACC), which blends the cost of its debt and equity financing. If you want a simpler starting point, the long-term average stock market return of roughly 10% works as a baseline discount rate for a company with average risk.
- Discount the cash flows back to today. Divide each year’s projected cash flow by (1 + r) raised to the power of that year number, then add up all the results. A spreadsheet makes this straightforward.
Adding a Terminal Value
A five- or ten-year projection doesn’t capture the value of a company that keeps operating beyond your forecast window. That’s where terminal value comes in. It represents all the cash flows from the end of your projection period into the indefinite future, and it often accounts for a large share of the total DCF value.
Two methods are common. The perpetual growth model (also called the Gordon Growth Model) assumes the company’s cash flows grow at a small, constant rate forever, typically 2% to 3%, roughly matching long-term inflation or GDP growth. The exit multiple method instead estimates what someone would pay to acquire the business at the end of your forecast, calculated by multiplying a financial metric like EBITDA (earnings before interest, taxes, depreciation, and amortization) by a multiple that reflects what similar companies have recently sold for. If comparable acquisitions in the industry have closed at 10x EBITDA, you’d apply that multiple to the company’s projected EBITDA in the final year of your forecast.
Once you have a terminal value, discount it back to the present using the same discount rate, then add it to the sum of your discounted annual cash flows. Divide the total by the number of shares outstanding, and you have a per-share fair value estimate.
Relative Valuation Using P/E Ratios
If DCF feels like building a financial model from scratch, relative valuation is more like comparison shopping. Instead of projecting cash flows, you compare a stock’s valuation metrics to those of similar companies or to its own historical averages. The price-to-earnings (P/E) ratio is the most widely used metric for this.
The P/E ratio is simply the stock price divided by earnings per share. A stock trading at $60 with $4 in earnings per share has a P/E of 15, meaning investors are paying $15 for every $1 of earnings. To estimate fair value, you compare that P/E against a benchmark:
- Industry peers. If the average P/E for companies in the same industry is 20 and your stock trades at a P/E of 12, it may be undervalued relative to its peers. If the stock trades at 30, it could be overvalued, or investors may be pricing in faster growth.
- Historical average. Compare the stock’s current P/E to its own five- or ten-year average. A stock that historically trades around a P/E of 18 but currently sits at 12 might represent a buying opportunity if nothing fundamentally changed about the business.
- The broad market. The S&P 500’s long-run average P/E hovers around 15 to 17, depending on the time frame. A stock with a P/E well above that should have a compelling growth story to justify the premium.
To turn a P/E comparison into a dollar estimate, multiply the company’s earnings per share by the P/E you consider fair (the industry average, for instance). If a company earns $5 per share and comparable firms trade at a P/E of 18, the implied fair value is $90 per share.
The P/E ratio isn’t the only multiple worth checking. Price-to-sales (P/S) is useful for companies that aren’t yet profitable, and enterprise value to EBITDA (EV/EBITDA) gives a view that accounts for differences in debt levels between companies. The logic is the same in each case: compare the company’s multiple to a relevant benchmark and see whether the stock looks cheap or expensive.
The Graham Number
Benjamin Graham, widely considered the father of value investing, developed a simplified formula for estimating the maximum price a defensive investor should pay for a stock. It’s less precise than a full DCF but offers a quick sanity check grounded in two fundamental metrics: earnings and book value.
The formula is:
Graham Number = √(22.5 × EPS × BVPS)
EPS is earnings per share, and BVPS is book value per share (the company’s total equity divided by shares outstanding, representing the accounting value of the company’s net assets). The constant 22.5 comes from Graham’s rule that you shouldn’t pay more than 15 times earnings or 1.5 times book value. Multiply those two ceilings together (15 × 1.5) and you get 22.5.
Graham recommended using the average of the past three years’ earnings per share rather than a single year, since one year’s results can be unusually high or low. If a company’s three-year average EPS is $3 and its book value per share is $25, the Graham Number would be √(22.5 × 3 × 25) = √1,687.5, which is approximately $41. If the stock trades below $41, it passes Graham’s test. If it trades well above that, it may be overpriced by value investing standards.
This approach works best for stable, established companies with real earnings and significant tangible assets. It’s less useful for high-growth tech companies or asset-light businesses where book value doesn’t capture much of the company’s worth.
Putting the Methods Together
No single method gives you a definitive answer, and professional analysts typically use more than one. A practical approach is to calculate fair value using two or three methods and see whether the results cluster in a similar range. If your DCF analysis suggests $85 per share, the P/E comparison implies $90, and the Graham Number gives you $75, you have reasonable confidence the stock is worth somewhere in that neighborhood. If the methods produce wildly different numbers, that’s a signal to dig deeper into your assumptions.
The inputs you choose matter far more than the formula itself. In a DCF, changing your growth rate by just two percentage points or your discount rate by one point can shift the result by 20% or more. With P/E comparisons, picking the wrong peer group can lead you astray. Treat any fair value estimate as an approximation rather than a precise answer. The goal isn’t to land on the “right” number to the penny. It’s to develop a well-reasoned range that helps you decide whether a stock is priced attractively, roughly fairly, or at a level you can’t justify.
Where to Find the Data You Need
Running these calculations requires a handful of financial data points, all of which are publicly available. Earnings per share, book value per share, free cash flow, and shares outstanding appear in a company’s annual and quarterly financial statements, filed with the SEC and available on its investor relations page. Financial data aggregators and brokerage platforms compile this data and make it searchable, often with built-in screening tools that let you filter by P/E ratio or other metrics. For industry-average multiples, look at financial data providers that track sector-level statistics, or simply pull the P/E ratios of five to ten close competitors and average them yourself.