What is the true worth or value or a publicly traded share or stock certificate? To put it another way, what is the value per share versus the current market trading price?
Does Book Value Provide Accurate Valuation?
Some fundamental investors use book value to suggest a company’s true value or worth. This is achieved by subtracting liabilities from assets. The net value of the company is what shareholders should theoretically receive if the company liquidated or went bankrupt. Should not then the book value per share be the benchmark for valuating a company? No, and here is why…
Two companies may have identical book values. The first company has high overhead and few growth opportunities. The second company is currently experiencing triple digit growth with big future prospects. Should both companies trade at the same price? Hardly, unless both companies are expected to be bankrupt and be sold off tomorrow. Book value is a static figure and we need a dynamic one.
Is Intrinsic Value the Answer?
Intrinsic valuation is another method to calculate current worth based on future growth. Here is how a simple version of this system can work:
- Stock XYZ trades at $10 per share
- The company earned $1 per share this year
- The price to earnings ratio is 10
- Stock XYZ is expected to earn $3 per share in 5 years
The analyst calculates that if the price to earnings ratio stays the same and the stock meets its earnings forecast, then the share price should triple in 5 years. This will result in a simple return of 40% per annum over the next 5 years. He can then calculate the desired and realistic amount of return. If his target profit is only 20% per year, then he is able to pay up to $15 per share to potentially double his investment in 5 years.
The problem with this intrinsic value calculation is that it assumes that the price to earnings ratio will remain constant and that future earnings will be met. Market conditions could hammer this stock down to a price to earnings ratio of 5, which would bring share prices down to $5. Also, if earnings dropped by 20% or to .80 cents per share, the price could fall to $4. If you bought shares of this stock up to $15 and watched it drop to $4 in a bad market, I am sure you would be less than pleased. Anytime a calculation is based on relative values such as price to earnings ratios, a big variable factor is introduced.
Is Market Value the Key?
Famous investors such as William J. O’Neil claim that the market value is the real value. After all, what someone is willing to pay is the final word in the matter, is it not? But does this provide the whole picture?
Imagine that two companies are identical in every way from earnings to net asset value and future growth. But one company is trading at two times the value of the other. How can this be? It could simply be from one company receiving momentum from a prominent news article. Is the one stock truly twice as good as the other for no other reason than an increase of news-following buyers?
Many investors would say no, the companies should be more closely valued. Either the one stock is overvalued or the other is undervalued and given enough time the market trading price should correct. If we say that the market value is the true value, then there is no basis to complain during bear markets or to call the markets irrational. We would need to assume it to be correct all the time, even while they crash for little apparent reason.
Fair Market Value the Answer
A slight variation of the above method is to use the average price over a period of time. If the stock traded as high as $12 dollars per share and as low as $8 per share, then the FMW or fair market value might be calculated at $10. This really solves none of the problems outlined in the above section, and is merely a smoothed average of the market price model.
Creating a Stock Valuation Model
As our brief discussion has highlighted, figuring out the true value of a stock is a mix of numbers and gut feelings. It can involve looking at:
- Assets and liabilities
- Depreciation and taxes
- Cash flow
- Earnings and growth forecasts
- Market cycles and their effect on financial ratios
- Historical price trends
Even after an analyst slaves over this data and makes his best projections, much is left up to how the traders view the stock. If the people trading the stock care little about fundamental data and ratios and panic sell, the stock will drop. If no new buyers come to the table, no matter how attractive the financial ratios are, the price will have difficulty in rising. Stock valuation models truly are a mix of science, math, art, and guesswork.