Question About Valuation? I'll Bite

3/23/2009


In the middle of an ugly day in the market, a man asked me a deceptively complex question.

He questioned the nature of stock prices and wondered why, in the face of economic weakness and stock-price declines, we value stocks at more than their net worth.

Subtract the sum of liabilities (what a company owes) from the sum of its assets (what it owns), and you have shareholders equity (also called book value), a decent proxy for a company’s net worth. Most public companies trade for more than their net worth. Even today, with confidence in the value of assets incredibly low, the S&P 500 Index trades at 1.4 times book value. Over the last 10 years, the index’s stock-market value has averaged 3.2 times book value.

Why the premium to net worth?

To answer that question, finance professors trot out equations for discounting future cash flows and preach supply and demand with fervor. Those concepts are key to stock valuation, but you don’t need a textbook to understand them. Consider two scenarios:

A tree by any other name
Suppose you and I each own an apple tree of the same size, with the same amount of fruit. Both trees should generate the same cash flows this year. Thus, they should have the same value. Unless . . . I don’t take care of my tree.

You have pruned and fertilized your tree, while I have let nature take its course, allowing barren limbs to crowd fertile ones. Your tree is likely to see its apple yield increase over time, while mine is on the decline.

Therein lies one component of valuation — future cash flows. In this case, we’re talking about the cash generated from the sale of apples. Your apple tree is worth more than mine because of the quality of your husbandry. An investor wishing to purchase the rights to 10 years of apple production should expect to pay more for your apples than for mine.

Example: Biotechnology concern Biogen Idec ($50; BIIB) and consultant Computer Sciences ($35; CSC) have similar book values. While Computer Sciences generates higher cash flow, its stock-market value is just 36% of Biogen’s. Biogen commands a higher valuation because investors are more confident in the company’s ability to grow.

You say tomato . . .
I love tomatoes, the fruit that eats like a vegetable. For purposes of our second example, assume you don’t.

Suppose my neighbor brings a basket of tomatoes to my home, where you and I are sitting in the kitchen. She offers me the basket of tomatoes for $5. I whip out the cash and revel in a good deal. She then offers you a basket at a similar price. You, not appreciating the succulent fruit, opt not to buy.

Did I pay too much? Did you miss out on a great deal? The answer to both questions is “probably not.”

That scenario illustrates another facet of valuation — personal preference. If the basket of tomatoes is a stock, I’m a buyer at $5. But you don’t like tomatoes and probably wouldn’t buy at $2.50.

Example: This one is simple. At the Forecasts, we prefer stocks with high Quadrix scores because they tend to outperform low scorers. Consider IBM ($93; IBM) and Goldman Sachs ($99; GS). Both trade at more than $90 per share, and Goldman’s book value is nearly five times that of IBM. But IBM earns an Overall score of 89, versus a 32 for Goldman, so we buy IBM and avoid Goldman.


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