Sunday, October 9, 2011

Lesson 13: How to Valuate a Stock, Company or Asset

If there's something that you must absolutely learn about stocks, this is not the most important. The most important lesson is Lesson 1, which teaches you how to relate a stock to an interest bearing savings account.

For this lesson, let's use the same grocery store from lesson 1. This grocery store makes $3 per year, every year. However, this was a very idealistic example, which was given to help you form an analogy between a company's income and a benchmark for you to compare it to. To make the example more realistic, let's add a new component. The grocery store now has a bank account, which has $100 dollars in it. Owning the business also entitles you the bank account. This complicates things because the math in Lesson 1 no longer works. In Lesson 1, we established that if we could buy the business for $10, we would be receiving a 30% rate of return when it earns $3 dollars per year. Buying this business for $10 would entitle you to an instant $90 profit because of the $100 already in the account. Clearly, such an opportunity would rarely occur, if ever. So, how much should the business cost?

We can think of this as a sum of its parts. We can divide the business into its assets and an income generating unit. We can then figure out the amount that we would be willing to pay for each part. It makes sense that we'd be willing to pay anything less than $100 for its bank account. After all, we don't lose anything in doing so. We established that $10 would result in a 30% return on investment for its profits. The sum of these yield $110. We're not REALLY paying $130 if we buy the whole company. We can take out the $100 for ourselves, leaving the actual cost still at $10.

This presents a problem for most of us, because we are usually partial shareholders. As a partial shareholder, you don't get to say how the company handles its money. It would be nice if the company paid out the $100 in a one time dividend if they didn't need to use it. That way, you can reinvest it somewhere else. Usually though, you'll at most have a partial say in what the company should do. If the company does not release the money, you are now effectively paying $110 to earn $3 per year, resulting in a 2.7% rate of return. The extra $100 being held by the company could probably be placed somewhere else to generate more money for you. Even though you bought the income generating portion for a wonderful $10, you're not getting rich anytime soon at 2.7% per year.

Consider though, that the company manages its money better, and only requires $5 of working capital. All excess money is paid out in the form of dividends. Now, we have a situation where the company only keeps $5 in its bank account. What should be the price now? Well, the money in the bank is worth $5, and if we can buy the income portion for $10, we'd be paying $15 total to own this business. Generating $3 per year, our $15 investment yields 20% per year. It's not as great as our 30% per year, but this is a far more realistic example.

We could take this one step further. Imagine that it only needs $1 of working capital and the building in which the business operates is worth $4, still totaling $5. This example shows the importance of Return on Equity and Return on Assets. It is not just the income generating portion of a company which is important, but the amount of assets that it requires to do it. This is why there are many companies which are profitable, but you don't see much increase in its stock price. It earns enough to pay its workers and expenses, and it won't be in any financial trouble anytime soon, but it will never make the owners rich.

No comments:

Post a Comment