How to Value Stocks: Equity-Based Valuations
Whether it's tangible items such as cash, current assets, working capital, and shareholder equity, or intangible qualities such as management or brand name, equity is everything that a company has if it were to suddenly cease selling products and stop making money tomorrow.
Traditionally, investors who rely on buying companies with a substantial amount of equity to back up their value were considered a paranoid lot hoping to collect something in liquidation. However, as the TV-dominated mass-consumer age has helped intangibles such as brand names create powerful moats around a core business, contemporary investors have begun to push the boundaries of equity by emphasizing qualities that have no tangible or concrete value but are absolutely vital to the company as an ongoing concern.
The balance sheet: cash and working capital
Like to buy a dollar of assets for a dollar in market value? Ben Graham did just that. He developed one of the premier screens for ferreting out companies with more cash on hand than their current market value. First, Graham would look at a company's cash and equivalents and short-term investments. Dividing this number by the number of shares outstanding gives a quick measure that tells you how much of the current share price consists of just the cash that the company has on hand. Buying a company with a lot of cash can yield a lot of benefits, because cash can fund product development and strategic acquisitions and can pay high-caliber executives. Even a company that might seem to have limited future prospects can offer tremendous promise if it has enough cash on hand.
Another measure of value is a company's current working capital relative to its market capitalization. Working capital is what's left after you subtract a company's current liabilities from its current assets. Working capital represents the funds a company has ready access to for use in conducting its everyday business. If you buy a company for close to its working capital, you have essentially bought a dollar of assets for a dollar of stock price -- not a bad deal. Just as cash funds all sorts of good things, so does working capital.
Shareholder equity and book value
Shareholder equity is an accounting convention that includes a company's liquid assets, including cash, hard assets such as real estate, and retained earnings. This metric is an overall measurement of how much liquidation value a company would have if all of its assets were sold off -- whether those assets are office buildings, desks, or old T-shirts sitting in inventory.
Shareholder equity helps you value a company when you use it to figure out book value -- literally, the value of a company written down on the accounting ledger. To calculate book value per share, take a company's shareholder equity and divide it by the current number of shares outstanding. If you then take the stock's current price and divide by the current book value, you have the price-to-book ratio.
Book value is a relatively straightforward concept. The closer to book value you can buy something at, the better it is. Book value, however, has a lot of skeptics these days. Depending on what tax consequences are being avoided, most companies can exercise some latitude in valuing their inventory and in reporting inflation or deflation on their real estate. But with financial companies such as banks, consumer-loan concerns, brokerages and credit card companies, the book value remains extremely relevant. For instance, in the banking industry, takeovers are often priced based on book value.
Another use of shareholder equity is to determine return on equity. ROE is a measure of how much in earnings a company generates in four quarters in comparison with its shareholder equity. It is measured as a percentage. For instance, if XYZ Corp. made $1 million in the past year and has shareholder equity of $10 million, then the ROE is 10%. Some use ROE as a screen to find companies that can generate large profits with little in the way of capital investment. High-ROE companies are so attractive to some investors that they'll take the ROE and average it with the expected earnings growth to figure out a fair multiple. This is why mature companies in industries that require little capital can have relatively low growth rates compared to their price-to-earnings multiple.
Brand is the most intangible element to a company, but it's quite possibly the most important one to a company as an ongoing concern. For instance, if every single McDonald's restaurant were to suddenly disappear tomorrow, the company could simply go out and get a few loans and be built back up into a world power within a few months. How can McDonald's do that? It's the company's presence in our collective mind. If people were forced to name a fast-food restaurant, nine out of 10 people would say "McDonald's" without hesitating. The company's well-known brand adds tremendous economic value, even though a brand can't be quantified.
Some investors are preoccupied by brands, particularly those emerging in industries that have traditionally been without them. Companies that build their names into strong brands have an incredible edge over their competition. A brand is also transferable to other products, in that it reduces barriers to entry in other industries, should a company decide to expand.
The real trick with brands, though, is that it takes competent management to unlock the value. If a brand is forced to suffer through incompetence, then many people can start to doubt whether the brand value remains intact. The major buying opportunities for brands, ironically, come when people stop believing in them for a few moments and forget that brands normally survive even the most difficult of short-term traumas.
Intangibles can also sometimes mean that a company's shares can trade at a premium to its growth rate. Thus, a company with fat profit margins, a dominant market share, consistent estimate-beating performance, or a debt-free balance sheet can trade at a slightly higher multiple than its growth rate would otherwise suggest. Although intangibles are difficult to quantify, that doesn't mean they don't have a tremendous power over a company's share price. The only problem with a company that has a lot of intangible assets is that a single danger sign can make the premium completely disappear.
The piecemeal company
Finally, a company can sometimes be worth more divided up rather than all in one piece. That can happen if there's a hidden asset that most people are unaware of, such as land that was purchased years ago and stayed on the books at cost despite dramatic appreciation of the land around it. Or it can happen simply because a diversified company does not produce any synergies. Keeping an eye out for a company that can be broken into parts that are worth more than the whole makes plenty of sense.
For more lessons on valuation methods, follow the links at the bottom of our introductory article.