Company Valuation

Breaking Down a Stock: Details of a Stock in Plain-English

There is an ocean of information available in regards to each stock, and at times it can be overwhelming. Hundreds of different economic indicators and news items guide stock prices over the short-term as traders place bets on near-term results of a company and the economy overall. Deep analysis is done on every aspect of a company’s current health and models of their future health, and you can see how it seems there are hundreds of financial experts on media outlets on both sides of every argument pertaining to a company’s near-term picture (that’s why CNBC has 30 people talking at the same time and it just ends up “rabble rabble rabble blah blah blah” as everyone argues counterpoints at the same time).

Thankfully young professional investors don’t have to focus on a lot of this. We will go through a lot of basic information provided on a stock since it is useful to know, but since we are placing long-term bets and not focused on predicting the near-term future (which is nearly impossible) then much of this analysis doesn’t pertain to our investment decisions. We have already seen the argument for investing in stocks over the long-run, so we will stick with that and let everything else run its course!

We are going to take the ocean of information provided about a stock and summarize it into three points to explain what drives the price of a stock. Add these to our long-term bets that we mentioned in the previous section that describes what drives a company’s success in the long-run, and we have enough of a picture to explain a stock price!

Dividend Stream:

Remember how a company generally looks at all the money it earns after paying interest to bondholders and paying taxes (net income), decides what it needs to keep to reinvest in new projects, and sends the rest off as a dividend payment to shareholders. When a company begins paying a dividend this represents a cash flow to the shareholder, and generally, under stable economic conditions, financial professionals can model this stream of cash for many years into the future based on many assumptions about the company’s business and economic conditions.

Without providing the detail on the math used to place a value on a stream of future dividends or how to actually model them, we will just break down three inputs in the equation:

1. Current dividend: In theory, if the company is paying a dividend now then the stock should be more valuable all other things equal. The bigger the better. Firms that don’t currently pay a dividend are likely companies that are growing quickly and need to keep the cash to reinvest in their business instead of paying it to shareholders. Once their growth slows they will likely begin paying dividends at some point in the future, and this is when the stream of money to the shareholders begins to be modeled.

2. Company risk: All else equal – the less risky a company is the better. If a company is currently paying a big dividend but they are involved in a very risky business (and their net income has been historically very volatile) then you can’t be assured that this dividend will continue forever. However, for a company in a very stable business there is less risk involved and thus a better chance of stockholders getting this dividend. If a risky company finds a way to lower their risk (ie due to a new product patent, or they signed long-term business contracts) then with that lower risk profile their share price should rise.

3. Company growth: Perhaps the most important and price-sensitive variable is the company’s growth. If a company is able to consistently deliver growth in their earnings then they will be able to continue to pass more money to shareholders. A company that pays a huge dividend now but that is unlikely to find steady growth in the future is not as attractive as a company who might pay a lower dividend now but has much more promising prospects to deliver long-term growth.

Company Buyout Prospects:

Small investors will usually focus on dividends as the source of their cash flow on their investment. But larger institutional investors and also companies themselves constantly analyze other companies and their ability to generate cash and earnings to see if they would be an attractive target for a takeover (thus the overall cash flow of the smaller company would become theirs should they purchase the smaller firm).

A company that is able to generate a lot of cash in their regular course of business by making money without having to continually spend a lot of money to keep the business going (known as positive cash flow) is a very attractive company for other firms. If a company in a similar line of business sees a smaller firm with these characteristics and other higher growth opportunities then they could acquire the company by buying all of the outstanding stock of a company.

However, they must offer a hefty premium to convince the smaller company to accept their offer. A company that wants to acquire another company has historically on average paid about a 30% premium to the current share price of the smaller firm in order to get them to agree to the deal. Investors look for companies that could be a target for a takeover due to the potential for an immediate sizable return. Therefore your company’s stock value will be higher if they generate solid cash-flow, have high growth prospects, and set themselves up to be purchased by other companies and large investors.

Relative Valuation:

The third main driver of a stock price is its relative valuation – or the price of a company compared to other similar companies in the same industry.

A common measure of a company’s value is their “price to earnings” or “P/E” ratio … seen as their current stock price divided by how much money they are expected to earn next year per share of stock outstanding. As of June 2016, this ratio on average for large U.S. companies was about 16:1 – or stocks were priced at $16 for every $1 the company is expected to make per share over the next year. So, if a company earned $3 million and they had 1 million shares of stock then they earned $3 per share. So, the average market ratio would suggest this company should have their shares priced at $48 (16 x $3).

This ratio will vary greatly across companies – generally with older and slower growing companies having P/E ratios below average, and younger and faster-growing companies having ratios above the average. But if two companies are very similar in that they have the same earnings, same growth prospects, and the same risk involved with their business … and one company is priced much more expensively (say with a P/E ratio of 20) and the other company is priced lower (say with a P/E ratio of 10) then investors will in theory buy the lower priced company and drive their share price higher and sell the expensive company which drives that share price lower.