Fair value gap is an important trading concept that denotes the gap between the current market price of a security or asset and the estimated fair or intrinsic value of it. Fair value gap can be understood and used properly by traders to gain a potential edge and increase profitability.
In this comprehensive guide, we will cover:
- What is the Fair Value Gap
- Why the Fair Value Gap Occurs
- How to Calculate the Fair Value Gap
- Using the Fair Value Gap in Trading Strategies
- Mean Reversion Strategies
- Pair Trading
- Event-Driven Trading
- Risks and Limitations of Trading the Fair Value Gap
- Fair Value Gap vs Other Valuation Metrics
- Fair Value Estimation Methods
- Tips for Successfully Trading the Fair Value Gap
What is the Fair Value Gap?
Intrinsic is also used to define the fair value of an asset or security, which plays a key role in identifying fair value gaps in Forex trading for spotting potential trading opportunities.
The fair value gap simply refers to the difference between the current trading price in the market and the estimated fair or intrinsic value.
For example:
- Current Share Price of Stock A = $50
- Estimated Fair Value of Stock A = $60
- Fair Value Gap = Current Price – Fair Value = $50 – $60 = -$10
In this case, Stock A is trading at a -$10 discount to its fair value estimate. The negative fair value gap indicates the stock may be currently undervalued by the market.
Why Does the Fair Value Gap Occur?
The gap arises due to a few key reasons why securities can trade above or below their fair value estimates.
- Inefficient Pricing. The fair value is not always priced in financial markets, so there are temporary mispricings away from the fair value.
- Investor Behavioral Biases. Investors’ cognitive and emotional biases in the short run can trigger misreactions that can pull stocks out of fair value.
- New Information. Market prices do not incorporate changing fundamentals and new information immediately.
- Future Growth Potential. If current valuations do not capitalize existing assets with high future earnings growth potential, markets can underprice the assets.
The main lesson is that fair value gaps are potential short-term arbitrage opportunities for smart traders until corrected back to fair value either by rational investors or by fundamental performance.
How to Calculate the Fair Value Gap
Here are the general steps for calculating the fair value gap:
- Estimate the Fair Value. Calculate the fair value by applying an appropriate valuation model. The common models used are discounted cash flow analysis, multiple-based valuation, asset-based valuation, etc.
- Obtain Current Market Price. Use financial data sources to find out the current trading price of the asset in the market.
- Take away Fair Value from Current Price. Just subtract your fair value from the price you can get on that asset today.
Fair Value Gap = Estimated Fair Value – Current Market Price
If the gap is positive, there is a possibility of undervaluation, whereas if it is negative, there is a possibility of overvaluation. The wider the fair value gap, the greater the mispricing of fundamental value.
Using the Fair Value Gap in Trading Strategies
Trading around fair value gaps is a strategy used by traders to profit from trades that occur around fair value gaps until prices revert back to fair value. Common trading tactics include:
Mean Reversion Strategies
Profiting from the assumption that extreme divergences from fair value will revert back to the mean or average is known as mean reversion.
Traders can buy undervalued assets with large positive fair value gaps and short-sell overvalued assets with large negative gaps. Income is generated when the price reverts to close the valuation gap.
In the case that strict risk management rules are in place, timing entry and exit points is critical. Most mean reversion strategies tend to incorporate such things as quantitative models, trading signals, and statistical analysis for precision.
Pair Trading
Pair traders create a long position in an underpriced stock, as well as a short position in an overvalued but connected stock in the same sector, positing that the hole will close over time.
For instance, an automobile pair trade might consist of a long position in an undervalued car company and a short position in an overpriced rival car company in the same segment due to the difference in valuation of the companies. The fair value gap shows the price gap of the mispricing between the two comparable companies.
Event-Driven Trading
Event-driven trading is a form of trading that profits from market overreactions and underreactions to news events, which create price divergences from fair values in the short run.
Traders look at the fundamental impact of earnings releases, merger announcements, regulatory rulings, clinical trials, etc., and take positions in order to capitalize on the closing of the valuation gap when the event occurs.
Rigorous fundamental research is required to estimate the fair value impact of market events for this strategy. Automated trading algorithms can also be designed around event-driven signals.
The key with any trading strategy is understanding that fair value gaps eventually converge through investor rationality, new information getting absorbed, or fundamental performance catching up. Patience and discipline are vital.
Risks and Limitations of Trading the Fair Value Gap
While trading around fair value gaps can be profitable, there are some notable risks and challenges:
- Inaccurate Fair Value Estimates. All valuation models depend on assumptions and estimates, which creates room for error in determining fair value.
- Market Irrationality. Markets can remain irrational longer than you can remain solvent. For an extended period, mispricing gaps could appear irrationally apart from one another.
- Fundamentals Change. Fair values are sensitive to shifts in underlying counseling fundamentals that drive cash flows and growth over longer-term horizons, while they may not be impacted by such changes over shorter-term horizons.
- Opportunity Costs. Waiting for mean reversion to occur can result in tying up capital with it locked up waiting for it to occur, thus likely missing opportunities with better-performing asset classes.
- Unpredictable Timing. Consistent timing cannot predict gap closures, necessitating prudent position sizing.
While ratios and models estimate intrinsic value, the prices that end up are prices that marginal buyers and sellers set. The instant these challenges are overcome is when you have mastered risk management, position sizing, stop losses, and trading discipline.
Fair Value Gap vs Other Valuation Metrics
The fair value gap is distinct from some other related valuation metrics:
- Fair Value Gap. Difference between market price and estimated intrinsic worth
- Discount/Premium to NAV. Difference between market price and net asset value per share
- Graham Net-Net. Difference between market cap and net current assets
- Relative Valuation. Compare valuation ratios like P/E and P/B between similar stocks
Proprietary modeling and analyst estimates of intrinsic value are the basis for the fair value gap. Net asset value and net-net are related to balance sheet data, while metrics such as this depend on it. Ratios between peers are referred to as relative valuation. Each has its merits in terms of what you are trying to achieve.
The most striking aspect of the fair value gap is that it focuses on estimating the fundamental value of an asset by modeling discounted cash flows, earnings, assets, growth, risk, and macroeconomic projections. It tries to measure absolute overvaluation/undervaluation.
Fair Value Estimation Method
There are several popular methods to estimate the fair or intrinsic value of an asset, which then allows calculating the gap from the current market price.
- Discounted Cash Flow Analysis. Projects future free cash flows, discounts them to today’s dollars using the weighted average cost of capital, and sums them to estimate fundamental value.
- Comparable Multiples Approach. Apply the valuation ratio averages of similar publicly traded companies to the metrics of the asset being valued to gauge its value. Common ratios include P/E, EV/EBITDA, P/B, and P/S.
- Replacement Cost Method. The replacement cost method calculates the cost to reconstruct all the tangible assets of a company in current dollars, minus depreciation, in order to measure asset value.
- Liquidation Value Approach. Estimates the total value left if a company sold all its tangible assets and paid off all liabilities in a liquidation.
- M&A Precedent Transactions. Analyze the valuation multiples of previous merger deals of comparable companies to intuit what a fair acquisition price may be.
Specialized equity research teams combine quantitative models with qualitative analysis into a weight-of-the-evidence approach to estimate fair value ranges for stocks.
Tips for Successfully Trading the Fair Value Gap
Here are some tips for effectively trading around fair value gaps:
- Use multiple models to cross-verify price divergences and reduce errors
- Employ prudent position sizing, limits, and stop losses on all trades
- Time entries and exits are made carefully using technical analysis and momentum
- Focus on highly liquid securities to avoid bid-ask spread costs
- Maintain trading discipline and stick to your process without emotions
- Update your fair value estimates frequently as new data is reported
- Specialize in a niche sector where you can develop an informational edge
- Utilize technology like algorithms and trading signals to enhance decision-making
But the key is to have a structured, rules-based process of the combination of valuation models, fundamental research, technical factors, risk management, and emotional discipline to profit from market mispricing relative to fair value.
Conclusion
Savvy traders can master the fair value gap in bull and bear markets for stocks, commodities, fixed income, derivatives, and currencies. As legendary investors like Warren Buffett have stated, “Price is what you pay; value is what you get.”
The basic foundation of the fair value gap is the difference between price and value. Traders can create structured ways to generate alpha by quantifying undervaluation with positive gaps and overvaluation with negative gaps.
Yet there is a need for precision in estimating intrinsic worth and risk management. Depending on the security under analysis, there are various fundamental and quantitative techniques used for modeling fair value. Using these models with some prudent trading tactics can result in success.
The fair value gap at the end of the day is a potential market inefficiency. Psychology and volatility can cause short-term price fluctuations, but they will eventually return to normal. This tendency towards mean reversion can well be used by savvy traders to make fortunes out of it.