Equity Market Fair Value (Morningstar)

A relatively accurate fair value could give the trader a feel for whether an asset's current bid/offer is respectively high/low. Valuation of general equity markets, or particular sectors, would intuitively take a truckload of number crunching, luckily it is available at Morningstar.

About the Morningstar Fair Value Calculations
source: How Fair Value and Target Price Differ
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To derive the fair value estimates, we use our proprietary discounted cash-flow (DCF) model. This model assumes that the stock's value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present. So, the first step is to project how much cash a firm is likely to produce over a number of years, and subtract the amount needed for capital improvements and increases in working capital to keep the business growing. Whatever profits are left over belong to the shareholders. The second step is to discount those profits to understand how much they are worth today.
 
As with any DCF model, the ending value is highly sensitive to the analyst's projections of future top- and bottom-line growth. In addition, the cost of capital, which is determined by the firm's capital structure and its riskiness, is another influential factor in the fair value estimate. (For more discussion of the nuts and bolts of Morningstar's DCF model, please see David Kathman's article "How Morningstar Values Stocks".)
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About Discounted Cash Flow Model
source: Wikipedia on DCF
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The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

where

• DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;
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• FV is the nominal value of a cash flow amount in a future period;
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• i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;
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• d is the discount rate, which is i/(1+i), i.e. the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year;
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• n is the time in years before the future cash flow occurs.

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Stock Fair Value estimate via Discounted Cash Model

So the Fair Value Graph at Morningstar, applying a Discounted Cash Model, caught my attention. It makes economic sense, has a positive correlation to the underlying indices, naturally I looked for details. The guy at "My Coverd Call Blog" made a pretty cool post explaining the formula:

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Benjamin Graham describes a simpler formula to determine intrinsic value.
Formula: V = EPS x (8.5 + 2G) * (4.4 / Y)
where:

• V: Intrinsic Value
• EPS: the company’s last 12-month earnings per share
• 8.5: the constant represents the appropriate P/E ratio for a no-growth company as proposed by Graham
• G: the company’s future long-term (five years) earnings growth estimate
• 4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced
• Y: the current yield on AAA corporate bonds

I use the modified formula from Old School Value, which uses a P/E of 7 for a no-growth company and a multiplier of 1.5G rather than 2G, since these are more conservative.

Modified Formula: V = EPS x (7 + 1.5G) * (4.4 / Y)
 
The original formula uses the last 12-month EPS (TTM), however, like Old School Value, I normalize EPS over a 10 year period, which estimates future EPS for the next 5 years, using a linear forecast based on the previous 10 years, and then takes the median of the previous 5 years and next 5 years to arrive at a normalized EPS. For estimated future 5yr growth rate I use 3 different sources, 1) Yahoo Finance, 2) Morningstar, and 3) MSN Money. I found that each site has a different 5yr estimate, so I use an average of these estimates."

We can see that the it's mostly straight forward, just that earnings expectations remain uncertain. So that is where more research remains to be done!