A lot of discussions have been devoted towards finding fair value of an investment. The goal of every investors is to find undervalued investment and sell it when it reaches fair value. Admittedly, this is the hardest part of investing. So, what is fair value? Fair value is a point where the price of an investment reflect its earning power.

Fair value is relative and it depends on other factors beyond the investors’ control. In here, we will discuss on calculating fair value within our own boundary of control. In short, calculating fair value of an investment depends on the rate of return expected and the risk taken to achieve that return. Higher risk needs higher reward. It is quite simple.

So, what asset constitute lower risk investments? We can only compare. First thing that comes out of my mind is Certificate of Deposit (CD). You are guaranteed certain return (interest rate), if you can hold for a certain pre-determined time frame. You would never lose your principal at the end of the time frame.

The next low risk investment is Treasury Bond. This is the bond issued by the United States government, which is deemed to be safest in the world. There are certain risks associated with the small fluctuation in the bond price. However, if you held the bond until maturity, you are guaranteed certain rate of return. Your rate of return depends to certain extent on the price that you bought the bond at.

The next higher risk investment is buying common stock. This is what we are going to focus more here. It is considered higher risk than the two types of investments mentioned previously because you have a higher chance of losing money on your investments. Earlier, we established that higher risk needs higher reward. Therefore, stock investing requires a higher reward.

So, what does this have anything to do with fair value? Quite simply, the price of a common stock that we buy must gives us a higher annual return than bonds or CD. For example if a CD gives you a 3% return, treasury bonds give you a 4% return, then you would want your stock gives you a higher return of perhaps 6%.

What does it means for a stock to give investor a return of 6%? It never really say it, doesn’t it? You are partly right. While it is not explicitly shown, you can do a little digging and find out how much the return of your stock investment would be. For example, if your Certificate of Deposit (CD) gives you a 2% annual return, for $ 100 of investment, you would earn $ 2 every year. Let’s assume that you want your stock to give you a return of 6%, which is higher than CD or treasury bond. This implies for every $ 100 invested in common stock, it needs to give us a return of $ 6 annually.

Where can we get this information? You can get it on Yahoo! Finance or other financial publications. All we need to do is find the share price of a common stock and the profit per share (also known as earning per share) of that particular stock. Let’s use an example to illustrate my point. Magna International Inc. (MGA) is expected to post a profit of $ 6.95 per share for fiscal year 2005. Recently, the share is trading at $ 73.00. The annual return of buying Magna stock is therefore $6.95 divided by its share price $ 73.00. This gives us a return of 9.5%.

Will Magna continue to give investors a 9.5 % return year after year? It depends. If the stock price rises, Magna will return less than 9.5 % annually. What else? Well, Magna might not constantly produce the same amount of profit year after year. It might even produce a loss! So, you see, stock investing is inherently risky because there are two moving part in the equation. Price of the common stock and the profits produced by the company itself. That is the reason why investor need to aim for higher return when choosing their stock investment.

All right. So, let’s move on to the crucial thing in investing in common stock. What is the fair value of Magna stock assuming a constant profit of $ 6.95 per share? Personally, I assign fair value of a common stock to be at least 2% above the rate of Treasury bond. Please note that I am using the 10 year bond here. Recently, treasury bond can give us a 4 % return. Therefore, the fair value of Magna common stock is when it can give me a return of 6%

So, what is the fair value of Magna common stock in this case? For a profit of $ 6.95 per share, the fair value of Magna common stock is $115.80 per share. That’s right. At $ 115.80 per share, Magna common stock will return investors 6% annually. Having said that, we should never buy a common stock at fair value. Why? Because our investing purpose is to make money. If we buy stocks at fair value, then when do we profit from it? Do we expect to sell it when it is overvalued? Sure, it would be nice if we can do that all the time. But to be conservative, let’s not bank on our stocks reaching overvalued level.

There you go. I have explained how to calculate fair value in a common stock. Of course, the $ 6.95 per share profit figure is the expectation of profit compiled by Yahoo! Finance. It is not in any way an endorsement to buy Magna common stock. You should do your own calculation to verify that number.

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When you are interested in investing in the stock market one of the first things you will need is a reliable and affordable stockbroker. At one point in time, a stockbroker was seen as a very high priced person that was extremely hard to understand. In todays world, stockbrokers have become much different, they have begun to make their services cheaper to obtain and in such a way that is easier to understand. This is an extremely wonderful change for the simple reason that you will not be able to trade in any way, shape, or form without a stockbroker.

One of the major rules within the stock market is that no person is allowed to trade within the stock market unless they are a certified stockbroker. A stockbroker, within the United Kingdom twelve million investors trade in the stock market, performs every trade that occurs and each one has enlisted the services of a stockbroker.

So you are probably now wondering, what exactly can a stockbroker do for me? There is a wide range of abilities and services that any stockbroker can offer you, at the same time there are also various ranges of fees that will be collected from them. Typically, a stockbroker will charge a commission, a set fee, or some combination of the two. In regards to the services a stockbroker can offer you, there are three basic levels that include only execution, portfolio management, and advice.

When a stockbroker only deals with the selling and buying of particular shares, per the instructions you give them, this is generally called execution only or in softer terms dealing only. With this type of service, they do not offer you any type of advice on any action you want perform. Typically, investors that are experienced or novice in investing will use this type of service. Execution only is cheaper and extremely efficient the fees the stockbroker charges can range anywhere between 20 to hundreds of pounds, this will depend on the specific stockbroker you choose.

Portfolio management is extremely detailed and the most expensive type of service performed and dealing with advice is typically a little more expensive than execution only, because the stockbroker will offer advice and views on what is happening within the stock market. The stockbroker at this level of service will also take the time to explain anything you may not understand very well.

Within the portfolio management service, you can separate these into two other categories these are advisory and discretionary. When under the advisory category, the stockbroker will create a proposal of a portfolio for you; however, he or she will not take any action without express permission from you. Within the discretionary category, your stockbroker will completely run all aspects of your portfolio and will give you reports as needs on how the portfolio is working.

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