Why the Fair Value Estimate Is a Big Freaking Deal

High and low are meaningless without a reference point.

Sarah Newcomb 03 December, 2019 | 10:33
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You wouldn’t buy a car without knowing its Blue Book value. You wouldn’t buy a house without an appraisal. Why would you buy shares in a company without knowing the fair value? Morningstar’s Fair Value Estimate is a smart shortcut that can help you find great companies at bargain prices and avoid getting trampled by the investing herd.

Following the Herd Can Lead to Ruin
Investors can act like buffalo that follow one another somewhat blindly. For instance, a rumor starts that XYZ company is going to be the next Google (GOOG) or Amazon (AMZN) and people start buying. As demand drives the price upward, the forecasts appear to be correct, and the herd starts a buying frenzy trying to get in before the peak. What we call a market “bubble” is when this race-to-buy pushes the price significantly higher than the stock is actually worth, until no one is willing to buy at the inflated price. At that point, someone starts selling at a slightly lower value so as to cash in at the peak. Bubble: burst. As the price drops, the herd panics, starting a selling frenzy that sends the price of the asset into the proverbial toilet. Behavioral finance folks call this “herd behavior” for obvious reasons.

We’ve seen this play out time and time again. During Tulip Mania in the 17th century, one tulip bulb sold for more than 10 times the average worker’s annual salary. In what Douglas-Adams-inspired universe is that reasonable? Ours, apparently.

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Sarah Newcomb

Sarah Newcomb  Sarah Newcomb is a behavioral economist with Morningstar.

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