Most any investment, whether it's buying a home or purchasing a stock, boils down to an initial outlay followed by (hopefully) a stream of future income. The trick is deciding on a fair price to pay for that expected stream of future income.
Let's say a stock trades at $20 per share. If you crunch the numbers--projected sales growth, future profit margins, and so on--you might estimate the stock's fair price per share to be $30. You pay $20 for the stock, and in return you receive a stream of income valued at $30. That's a great deal. If the stock was trading at $40, above the $30 fair value of the future income stream, you are looking at an expensive stock.
At Morningstar, our analysts estimate a company's fair value by determining how much we would pay today for all the streams of excess cash generated by the company in the future. We arrive at this value by forecasting a company's future financial performance using a detailed discounted cash-flow model (see Stocks 403) that factors in projections for the company's income statement, balance sheet, and cash-flow statement. The result is an analyst-driven estimate of the stock's fair value.
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