How fair value is worked out

In short

Fair value is an estimate of what one share is worth, based on the money the company makes and how fast that has grown.
We work it out twice: once from profit and once from cash. When the two are far apart, that is worth a closer look.
The margin of safety compares that estimate with today's price. Positive means the share costs less than the estimate, negative means it costs more.
Every company is measured the same way, from its own filings with the SEC. Nothing is picked by hand.
It is an estimate, not advice. It says what the past suggests if it carries on, not what will happen.

Step by step

The same four steps for every company

Step	What happens
1. Start with what one share brings in	What the company earned per share over the last twelve months. We do it twice: once with profit (earnings per share) and once with the cash that is actually left over (free cash flow per share).
2. See how fast that has grown	The company's own growth over the past years, using averages of three years so that one unusually good or bad year does not decide everything. We keep it between 5% and 20% a year.
3. Look twenty years ahead	We let that figure grow at the company's pace for 10 years, then at a calmer 4% for 10 more. No business grows fast forever.
4. Turn future money into today's money	A dollar in ten years is worth less than a dollar today, so every future year counts for less. How much less is set by the discount rate, today 11%. Add all the years up and you have the fair value of one share.

Reading the margin of safety

How far the price sits below the estimate

An example: a fair value of $100 and a price of $70 is a margin of safety of 30%. The share costs 30% less than the estimate, which leaves room for the estimate to be too optimistic.

Margin of safety	What it means
30% or more	The price is well below the estimate: a clear discount.
0% to 30%	The price is below the estimate, with only a small cushion.
Below 0%	The price is above the estimate. At minus 100% you pay twice what it is estimated to be worth.

When there is no fair value

The company lost money, or burnt cash, over the last twelve months. There is nothing to grow.
It made a loss at the start or the end of the period we measure growth over. Growth out of a loss cannot be worked out.
It has filed fewer than 3 years in a row, or its latest figures are more than about fifteen months old.

Good to know

Steady or uneven. Steady means the company earned money every year and rarely went backwards. With an uneven record the estimate is much less certain.
A short history. With 3 to 5 years of figures there is too little for averages, so growth is read from the first year to the last. The stock page then says the fair value rests on fewer years, and it is less certain.
Small changes matter. A slightly different growth rate moves the fair value a lot, so treat it as a rough guide, not an exact price.
Banks, insurers and property funds get a fair value with a warning: their profit and cash flow work differently, and this method suits them less well.

The details, for those who want them

It is the standard two-stage discounted earnings model:

fair value = base × [ x(1 − x¹⁰) / (1 − x) + x¹⁰ × y(1 − y¹⁰) / (1 − y) ]
x = (1 + growth) / (1 + discount rate), y = (1 + 4%) / (1 + discount rate)

Earnings per share is diluted EPS as filed, over the last twelve months: the last annual figure, plus the year to date from the newest quarterly report, less the same months a year earlier.
Free cash flow per share is operating cash flow less capital expenditure over the same months, divided by the newest diluted share count.
Growth compares the average of the last three years with the average of three years as far back as the filings reach, between 3 and 10 years apart. With fewer than 6 years in a row, the first year against the last.
The discount rate is the 10-year US Treasury yield plus 6 points, rounded up to a whole percent: today 4.99% plus 6, so 11%. The same for every company.
Share splits are taken out before growth is measured, or a 4-for-1 split would look like earnings falling by three quarters.

Where this differs from the usual version: that one uses earnings without non-recurring items, which SEC filings do not tag, and measures growth between single years rather than three-year averages.