FOOL PLATE SPECIAL
How can a company be worth less money than it has in the bank? Easy. Cash supplies often have little to do with valuation, so don't assume the market is mispricing a security just because its per share value is less than its cash reserves. It makes perfect sense in a forward-looking market.
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Barron's writer Jack Willoughby wrote a story (subscription required) in Sunday's edition about struggling Internet companies that could make interesting investments. He added the right flags in his piece -- saying, for example, that most of the companies on the list will go out of business -- but investors should follow up with caution. Willoughby is treading in dangerous fishing grounds, and the vast majority of investors should stay away from penny stocks. That said, there's a bit of fortune hunter in most investors. Diligent investors can find valuable investments in downtrodden sectors. It just takes a heck of a good investor and a little luck to separate gold from fool's gold. Barron's turned up a list of 70 companies with no long-term debt, and cash per share on their balance sheets that exceeds the company's stock price. How can a company be worth less than its cash? This isn't an uncommon situation, and investors should be careful not to mistake it as an example of the market mispricing a security -- just as investors shouldn't assume companies trading below book value are underpriced. Most aren't. Investors looking at struggling companies need to know how much cash a company has for obvious reasons, but cash supplies have little to do with valuing an investment. A company's value is equal to the present value of its future cash flows -- meaning money produced by the company's business -- not money sitting in the company's bank account generated by public offerings or debt. Most of that money is going to get spent. Since shareholders don't have access to a company's cash hoard, 99% of the time it isn't worth anything to them. These valuations all relate to the value of $1. Investors will pay more for $1 of Microsoft's (Nasdaq: MSFT) earnings than for $1 of General Motors' (NYSE: GM): Just look at their respective price-to-earnings ratios. This discrepancy is based on Microsoft's greater profitability, potential for growth, and track record of returning value. In other words, the value of $1 is different depending on the future payoff, as it should be. The same is true for these Internet stocks. Even if you ignore the time value of money -- which the market doesn't -- investors are presently looking at these businesses and betting, correctly, that they won't be able to turn that $1 of cash into anything like $1 of profits. Most of them just aren't viable businesses. The subsequent valuations, therefore, are axiomatic. It makes perfect sense that these stocks should be valued at less than the value of their cash reserves, since most will go out of business without creating value for shareholders. If a company doesn't have enough cash to pay its bills, game over. Your analysis is done. But assuming it does, what matters in terms of valuing its potential is the strength of its business plan. Is it a company that can make money and return those profits to shareholders, either in the form of dividends or share price appreciation? Most of these companies have already been hit by the mallet. They just haven't toppled yet. Richard McCaffery was hit by a shillelagh once. His stock holdings can be viewed online, as can The Motley Fool's disclosure policy.
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