Price = Fundamentals + Exuberance

One way to judge whether a stock is cheap is to split its price into two parts: the fundamentals — what the company's earnings actually justify — and the exuberance, which is whatever Mr. Market tacks on top.

Say you like a company trading at 21 times earnings, and its stable forward earnings justify about 15 times. Then:

Price (21x) = Fundamentals (15x) + Exuberance (6x)

You would be paying a 6x premium for other people's excitement. Not cheap.

The same math identifies bargains. If a stock trades at 25x earnings but its fundamentals justify 29x, the exuberance is negative 4x — you are buying at a discount. A good company whose price has been pushed below its fair value by pessimism is exactly where the contrarian finds opportunity.

How to estimate a fair valuation

Start with the historical P/E ratio as one data point — lower is generally better. Then weigh the company's forward earnings guidance to decide what a fair value looks like. The real edge lies in judging that future guidance.

In short: if the P/E is dropping while forward earnings guidance is trending up, it can be a good sign to turn bullish. These moments don't come often — maybe a few times every couple of years — so be patient. And when one arrives, be calm: set impulse aside and make the contrarian move deliberately.