These Stocks Aren't Worth What You Think

When you're trying to figure out what a company is worth, the stock price is the obvious first place to look. But if that's the only thing you look at, you're going to make some huge mistakes in your analysis -- and you might make some investment decisions you'll later regret.

By itself, a company's market capitalization -- the total value of all of a company's shares -- provides a lot of information about what the market thinks a company is worth. But with certain companies, market cap gives a misleading picture about a company's ability to generate future profits. To get the full picture, you really need to pay close attention to items you'll find on the company's balance sheet, especially cash and debt levels, and the impact they're having on the business.

Valuation 101
As an example, let's start with one of the most basic valuation measures: the price-to-earnings or P/E ratio. Obviously, it depends on the stock price to provide half of its input. Lots of people automatically assume that stocks with high P/Es are overpriced, while low-P/E stocks are cheap and good buys.

Most criticism of P/E ratios stems from the fact that the other input value, earnings, is subject to accounting manipulation. Share price, on the other hand, seems simple by comparison: they're set by the market rather than determined by representatives of the company. How could share prices be deceiving?

Well, one thing to remember is that a stock's price includes the value of cash and short-term investments that a company makes. Although that cash may be useful for other purposes, it doesn't generally contribute much toward a company's earnings -- especially when short-term interest rates are extremely low, as they are now.

So when net cash represents a fairly substantial component of a company's balance sheet, you should make allowance for it when calculating valuations based on earnings. By using enterprise value (EV) rather than market cap as a basis for valuation, you can isolate productive assets that actually contribute to creating earnings. As you can see below, that has a particularly large impact on these cash-rich stocks:

Source: Yahoo Finance; Capital IQ, a division of Standard and Poor's.

All of these stocks have a lot of net cash relative to their market caps, and so for all of them, traditional P/Es will give a number that's higher than what you get using enterprise value. Since EV focuses on a company's productive assets, it's often a better indicator of value -- and for the above stocks, makes them look more attractive from a valuation standpoint.

Dealing with debt
The same is true on the other side of the coin -- with companies that have a lot of net debt. Let's take a look at that from a slightly different perspective.

Another way to assess a stock's attractiveness is by looking at return on equity. Investors see companies that have high returns on equity as making productive use of their resources and thereby justifying high share prices.

But sometimes, companies produce high returns on equity by using extensive debt financing. That can produce a large discrepancy between its return on equity and its return on capital, which takes borrowing into account. Look at these debt-laden stocks:

Source: Yahoo Finance; Capital IQ, a division of Standard and Poor's.

In these cases, enterprise values are much higher than market caps. So in essence, these companies are using far more capital in order to generate their profits -- and they're not as attractive as their returns on equity suggest.

Debt isn't automatically bad. When credit is freely available and cheap, leverage can work out great for shareholders. But if credit tightens and these companies can't find attractive refinancing for their debt in the future, each of them could lose more money to debt maintenance and have less left over in profits. If you're not careful, you may put too high a value on these companies -- not realizing that they're vulnerable to the whims of the credit markets.

Look at the whole picture
It's tempting to stick with simple measures in assessing stocks. But by looking deeper, you'll learn more about the companies that interest you -- and sometimes uncover pitfalls you might otherwise have missed. That makes an extra look well worth the effort.

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