The Motley Fool: What's a stock's fair value?

Ask the Fool

How do you findtrue value?

Q: How can you figure out a stock's fair value? - T.N., Butler, Pa.

A: A stock's fair, intrinsic value is not necessarily the same as its current price. Determining it isn't easy, and many skilled stock analysts will arrive at different numbers. They often employ "discounted cash flow" analysis, estimating future free cash flows and assigning them present values based on chosen discount rates. That may sound precise, but it's still based on guesses.

Individual investors often employ simpler approaches to valuation, such as comparing a company's price-to-earnings, or P/E, ratio to its growth rate. If the growth rate is much higher, the stock may be undervalued. You might alternatively compare the company's current P/E ratio with its historical P/E ratio range or average P/E, which you can find at sites such as Morningstar.com. If the stock's five-year average P/E ratio is 17 and it's at 24 now, there's a good chance it's overvalued.

Remember, though, that P/E ratios will vary by industry. Automakers, for example, typically sport low ones, while less-capital-intensive businesses such as software companies often have higher P/Es.

Don't rely on any one method alone. Gather lots of information..

Foolish Trivia

Name that company

I trace my roots back to 1962 when a funeral director founded me in order to buy up more businesses. He achieved economies of scale by having funeral homes near each other share resources and make services such as embalming and transportation more efficient. Over the years I acquired competitors such as Alderwoods Group and Stewart Enterprises and The Neptune Society - America's largest cremation service provider. Today, based in Houston, I'm North America's largest death-care company, with my Dignity Memorial network recently encompassing more than 2,000 funeral homes and cemeteries. I employ about 24,000 people. Who am I?

Last week's trivia answer: Phillips 66

the take

Getting profit from generics

If you're looking for a growing stock that offers dividend income, take a closer look at Teva Pharmaceutical Industries (NYSE: TEVA). Teva is a hybrid drug developer, generating substantial revenue from both branded drugs and generic products.

Branded drugs provide the juiciest profit margins, but they have finite periods of patent exclusivity. Once a drug loses its patent protection, generic makers tend to start offering less expensive substitutes. Conversely, generic drugs feature lower profit margins, but there's a strong stream of opportunities, as branded drugs keep coming off patent. Additionally, generic drug prescriptions are growing in the U.S.

More important, Teva is in the process of acquiring Allergan's generic drug business for more than $40 billion. Following completion of this deal, Teva will cement its spot as the world's No. 1 generic drug developer and will have more power to negotiate with public and private payers. (The Motley Fool has recommended Teva.)

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