Talk

Stock valuation

A company's stock is evaluated using many different criteria. If there were one fail-safe mechanism the stock market wouldnt be the big game it is. Here we consider some of the things to look for in a company.

Financial Health: The financial health of a company is not that different from the financial health of an individual. The D-word is key. How much debt a person has indicates the financial well being of a person. For example people prop up their debt with the help of collateral or income. People take second mortgages on their house to increase their debt levels. Credit card companies extend lines of credit based on your income. A company is not different. Financial leverage is:

Assets/Equity

It reveals how much of the assets is backed by equity as opposed to debt. Look at companies that have low debt and high free cash flow. WCOM (Worldcom) has $37 billion as debt on its books. Its market capitalization is about $10 billion.

Profitability: Essentially when you buy a share you are investing in the company. You do this because you believe the company will give you a positive return on investment. If the return on investment was 3% you'd be better off leaving it in your savings account and stay safe without weathering the risk. ROE (Return on Equity) is a crucial measure of a companies profitability (and as a consequence your return on investment). Depending on the business several factors are needed to increase profitability. When times are rought management boosts profitability by reducing expenses (read: layoffs, stop coffee, employee perks). In order to increase revenue Chilli's would have to do one of the two:

1. open new stores
2. increase sales at existing locations

Growth: A stock's price in theory reflects the value of the company. GE is worth close to $200 billion because investors believe that if the company were taken apart it would yield $200 billion dollars. However, in the next year if GE's revenues increased then it would be worth more. In reality a stock's price reflects where investors think the company is going to go.

Valuation check: A stock's valuation is checked using calculations such as P/E (price per earnings), P/S (price per sales) or P/B (price per book value).

Earnings as discussed previously is the profits of the company. P/S marks a company's price against its sales. In the hey day of the internet craze the stock market placed all its bets on increasing sales with no focus on the profitability. As a result companies were urged to grow as fast as they could with little or no focus paid to the bottom line. Book value of a stock is what its worth in hard assets. This is a very pessimistic way of looking at a stock since you then believe that the company is worth no more than what cash it has in the bank and the buildings it owns.

Right before PC Order (PCOR) was bought by Trilogy its valuation was $65 million. PC Order had $66 million in the bank!. But if a stock is totally undervalued then book value is a great indicator of whether it's worth investing in that company. Currently Worldcom (WCOM) has a market capitalization of less that $10 billion with a share price of ~$2.50. It has a book value of ~$18. So why is Wall Street hurting this stock so badly? In my personal opinion all companies with substantial debt on their balance sheets ($37 billion in wcom's case) are tainted with the Enron syndrome; investors do not trust their books.

The factors we discussed above all work well until we encounter debt. P/E ratio's do not consider the debt burden of the company. Apply these terms to the financial health of an individual we find the example of Joe Schmoe making $50,000 a year (revenue) with savings (earnings) of $20,000. The P/E for Joe Schmoe (assuming he is incorporated with 10,000 shares trading at $10) would be well placed (5). However if Joe were carrying $100,000 of student loans we'd be unduly optimistic of Joe's potential.

Enterprise multiple takes into account the debt burden of a company. The enterprise multiple is calculated as follows:

Company market cap
+ liabilities (debt, etc)
- cash, inventory, assets

---

total cost to buyer (enterprise value)

Now to get enterprise multiple

enterprise value/Operating Income

Operating income is (revenues - cost of revenue - Operating expenses)

When the Enterprise value for a company is more than its P/E then its a tip that the company has sizeable debt. Learn more about enterprise multiples at Forbes

coming soon....
Barrier to Entry, Price Elasticity, Capital Intensive, Substitute, Regulation

Posted at April 30, 2002 08:58 PM