How to Value a Stock

Today, we would like to talk about how to value a stock. In the short term, stocks are subject to wide swings of optimism and pessimism. This is one of the first concepts that investors must understand. Do you really think Yahoo! is worth, $90 billion? If so, than you think it is worth two times the combined value of Harley-Davidson, MBNA Corporation, Tiffany & Co., and Wrigley Gum. Does this make sense given that these four companies have proven records of profitability over several years, with no slowdown in sight? Of course it doesn’t but these are the types of events that can occur in euphoric bull markets. This is similar to the tulip bulb craze of the 1600s when people senselessly bid up the price of tulip bulbs until eventually prices collapsed. We have no view on when the current craze in Internet and other stocks will end, but rest assured that there will be a major shakeout in this industry. The Internet is about as close as you will get to a perfect competition model and many of the players will lose.

Now, on to how one should go about valuing a stock. The first thing to realize is that a stock is part ownership of a business. It isn’t something you should buy just so you can sell it a day later. The value of an asset, whether it is a stock, a bond, or real estate, is simply the sum of all the cash that can be taken out of it over its lifetime. Of course, determining what you can get out of a stock is by no means an easy calculation. This exercise gets dramatically simpler if the investor focuses on a company where the possibilities of profitability continuing into the future are a near certainty.

The value of a stock is a function of all the cash that can be taken out of it during its life.

Right away, you see that we have no real idea how much a company is worth if we are uncertain that they will be able to produce profits. Why investors, a better term here is speculators, would want to put their hard earned money into a stock that may never make a profit makes no sense to us. One thing is for sure, you will never see us recommend a stock that doesn’t earn a profit. An analyst can and will use all the mathematical magic he wants to try and justify how much an unprofitable enterprise is worth. We have no interest in playing this game. Yes, speculators may score on these types of companies from time to time, but over time, the law of averages will catch up with them. What makes the average person think they can outsmart everyone else who’s trying to play the game?

Investors should avoid companies with unproven and unprofitable business models.

The next key point centers around net income. Although many are impressed by a company that shows increasing net income over time, such increases do not guarantee that the company is creating shareholder value. A company that has to continually invest more and more capital into its business just to keep its profitability rising, is not a desirable. A quick check of the type of company you’re dealing with is to look at its returns on invested capital over time. Return on invested capital is simply a measure of how much operating income a company earns as a percentage of all the capital tied up in the business. If the company earns returns on its invested capital in the range of long term returns on government bonds, there is really no reason to invest in it. Because year after year, the company is really making no economic progress, no matter how much its reported income is growing. We can’t emphasize enough how important this concept is.

Net income is a necessary but not sufficient indicator of a value-creating enterprise.