Stock prices are set by the market, supply and demand. They are generally based on a company's financials (how well its business is doing, how much profit it earns, etc.), but the influence is indirect. Moment to moment, prices gets set by the action of buyers and sellers.
Because of this, stocks sometimes get pumped up by unrealistic hopes, or held down by specious concerns. The prices get out of whack compared to the actual financials the company produces.
“This new web browser may have 0.1% market share now, but someday it will bury Google!” “This new smartphone may only be available in Lithuania now, but once it launches in the U.S., bye-bye iPhone!” And so forth.
Created by investor and Columbia professor Bruce Greenwald, Earnings Power Value attempts to discover the fair value for a stock based on its current earning power. Not the hope of business bloggers or the dreams of a fast-talking company CEO, but what the firm's financial statements say now.
In its most basic form, EPV represents the ratio of a company's earnings to its cost of capital. It answers the question: how efficiently does the company turn invested money into profit?
In practice, the math to calculate EPV can get complicated. The actual formula divides adjusted earnings by the weighted cost of capital, or WACC.
There's a long process of finding an adjusted earnings figure...the core profit a company earns without things like interest, taxes, amortization and one-time charges. It also looks at an average over a long period of time to get rid of the regular fluctuations of the business cycle.
A similar series of mathematical maneuvers turns cost of capital into weighted cost of capital. Once all the arithmetical gymnastics are done, you can use the EPV number to compare the intrinsic value of the stock with the market value.
You can see whether the stock price is low compared to its current earnings power (suggesting the stock is undervalued and will eventually go up) or whether it is too high (suggesting the stock is overvalued and will eventually go down).
Related or Semi-related Video
Finance: What is Fair Market Value?3 Views
Finance a la shmoop what is fair market value? double bubble toil and trouble [Man casting a curse]
what is the fair price of this pile of rubble so this term revolves around the
notion of fair like what is fair and by the way who told you the world was fair
anyway all right but financially fair or at least fair market means what the
market will fairly and legally pay for an asset that's fair and so that means [Man discussing financial fair]
fair as in not cash from a Somalian warlords leather briefcase but rather
fair as in the legitimate selling price of this excellent two-bedroom three-bath
shoebox in Palo Alto selling for 3 million dollars today for something to
be "of fair market" the buyer has to be knowledgeable and
unpressured i.e the somalian warlord does not in fact have a gun aimed
at the buyers head or any other body part and generally speaking [Gun aims at buyers body parts]
the market itself has to be a legitimate market like real estate or jewelry or
stocks or bonds or whatever if it's an illegitimate market well it's a probably
wondering why it was born out of wedlock so you can't do that
when you assess fair market value things have to be legal and liquid and well
fair whatever the market will pay for it that's the fair value [Hand dealing out cash]
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