This article on understanding how to value a stock well was written by Net Net Hunter member Bryan Shealy. Bryan worked in the inventory business for 5 years which gives him an edge in net net investing. Article image under CC 2.0 by cafecredit, edited by Broken Leg Investing.
Do you often wonder if you are getting a great price on a stock? Would you like to cut through all of the buy-and-sell media noise? If you dont value a stock well then you may end up paying the price.
All investors should really be evaluating stocks based on their intrinsic value, but so often we know that this is not the case. Despite the enormous importance on price-to-value comparison, many investors simply disregard it! Instead, they buy based on the fear of missing out on a great opportunity, or because they recognize the value of the company and have money for investment. They rationalize their purchase, assuming that the stock will never be cheaper or that they may miss the chance to buy. This irrational thinking leads to purchasing overvalued stocks.
In reality, there are many ways to value a stock and determine the appropriate price point. Some methods include:
- price to earnings ratio (PE)
- price/earnings to growth ratio (PEG)
- price to book value (P/B)
- net current asset value (NCAV)
[Broken Leg Investing analyst's note: PE ratio is number of times the stock is trading for company’s latest earnings. In simple words, if the earnings of a company is $1 per share today and its market price is $10 per share then PE ratio is 10x which is 10 times multiple of company earnings]. Price to earnings valuations (PE) usually compare the firm’s PE ratio to that of other companies in the same industry or in the overall market. A company with a PE ratio above or below the average PE ratio for a company in that industry should therefore be overvalued or undervalued respectively.
Price to earnings growth ratio (PEG) attempts to use historical growth rates to predict future value. According to this tool, the lower a PEG ratio is, the better value the company has compared to its price. (Side note: it’s interesting to me that all investment disclaimers explain that “past results are not indicative of future results” yet we rely so much on the past as an indicator.)
Price to book ratio (P/B) actually attempts to value a company’s current value and is a fairly conservative way to value a stock. It attempts to capture liquidation value based on all assets, both current and long term. Depreciation of assets and fire sale liquidation, however, pose a problem in determining the true liquidation value. A more conservative variant is comparing the price to net tangible assets.
Finally, net current asset value (NCAV) takes an ultra-conservative liquidation value and focuses only on current assets, assuming that all long-term assets are free. Any company that is priced below net current asset value can instill confidence in an investor, especially during market downturns.
It’s important to understand the various ways to value a stock to avoid being sold a product. There are plenty of buzz words in the investing world that make you feel good about your stock price purchase, like ‘buy the dip’ or ‘intrinsic value’. These phrases tend to get trotted out when somebody wants you to make a purchase. As an investor you need to cut through this noise and answer the question, “How do I know I’m getting a great price?” Not only that, but you need to have confidence in the price that you are paying.
Take for example a stock like Netflix. The Price to book ratio is enormous. Clearly this stock is overvalued. However, many investors tout this as a great growth stock and one to buy and hold forever! Even now! They calculate factors like intrinsic value and future growth drivers as a way to push the price of the stock to a sky-high value of 278.52. It will be a bargain years from now, and if it continues to make profits, that price will have paid for itself. However, if Netflix stumbles and and its PE drops, what are you left with? A stock that you bought for 33.68 times its assets! Does that sound like a great price to you?
Netflix Stock Price: 278.52
New value investors need to look closely at price and how it relates to stock value. They need to have complete confidence in the price they pay for a stock. It can be very difficult to calculate a fair price to pay for a growth stock or any of the large cap stocks available. With Benjamin Graham’s Net Net investing strategy it’s easy to calculate a fair price to pay by calculating a stock’s actual physical value. The key to this strategy is using net current asset value, or NCAV.
NCAV takes the guesswork out of future value and calculates the value of a stock in today’s dollars. You no longer have to be a wizard or see the future!
NCAV investing takes an ultra-conservative approach to valuing a stock which leads to much more confident price points. Using NCAV, you are only taking the current assets of a company into account, the most liquid part of the business. In fact anything you pay below the NCAV is by definition paying pennies on the dollar for an asset.
If we were to use NCAV to value Netflix (admittedly a very flawed way to value this firm), we could see just how overvalued the stock price is. We can do this by subtracting its total liabilities (15.431B) from the sum of its current assets (currently valued at 7.670B), which gives us -7.761B. We then take the NCAV of -7.761B and divide it by the number of outstanding diluted shares (448.16M) to get a stock price of -$17.32. Now this is an extreme example, but it does highlight a point. In essence the company has taken on so much in terms of liabilities that if it never made a profit ever again, or even if it closed its doors tomorrow, you would be left with nothing.
A more realistic way to value Netflix would be the PE ratio. Looking at the company, we can see just how much investors are paying today for the promise of future growth. A PE of 223x is insane given the market's roughly 30x PE. If you are looking to start value investing, you need to stick to much cheaper firms.
Most companies today have taken on such large amounts of debt, it’s scary. This can affect the price of stocks in a much more negative way than any future profits might. A great price can more easily be spotted for companies with much lower levels of debt. The company should always have a reasonably small amount of debt or you're just speculating on the future. It is much more likely to go bankrupt.
Price plays an important role in expected returns for a value investor. The cheaper a stock is, the higher its potential for compounding becomes. Among the various ways to value a stock, NCAV is the most conservative. Not only does this method instill confidence in the investor, but it’s also an easy way to evaluate potential returns. There is a huge difference between a stock trading at 66% NCAV vs. a stock at 33% NCAV. A stock valued at 1/3 of NCAV can triple before reaching its actual NCAV, whereas a stock purchased at ⅔ NCAV cannot even double before hitting NCAV.
Create a sense of confidence in your investment by opting for a large margin of safety in terms of the price you pay and balance sheet strength you demand.
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