The Fundamentals for Valuing Common Stock Investments
The U.S. stock market has proven to represent the most efficient means to invest over long periods of time. Efficiency is defined as stellar risk – reward characteristics over cash equivalents, bonds, real estate, and commodities. Indeed, historical stock market returns trend towards 11% per various metrics including the Standard and Poor’s 500 Index and Dow Jones Industrial Average.
Of course, investors are not always able or even willing to buy “the market.” Making money on stocks is often linked to individual stock selection and mining for value. Investors must decide if actually beating the market is worth it, or even possible, prior to discovering the separate strategies to value stock.
Beating The Market
Beating the market means to invest at a greater rate of return than is available per the benchmark S&P 500, Dow Jones, and Wilshire indices for a set period of time. Despite impressive technology, well-trained business minds, and meaningful intent, few individual stock pickers actually outperform the market.
According to John Bogle’s “Common Sense on Mutual Funds,” only “one out of every six managed equity funds succeeded in outpacing the market’s return” during the height of the 1982-200 bull market.
Bogle is the father of Vanguard and stresses the passive approach to index investing. Index mutual funds do allow investors to “buy the market” and matches modern portfolio theory, which says that individual stock selection, is a futile game of chance. Of course, legions of active investors will argue that impressive returns are possible by learning how to value and buy common stock.
One share of stock actually represents one ownership claim to the equity and earnings potential of a corporation. We calculate market capitalization by multiplying the individual share price by the total shares outstanding of the corporation. Market capitalization is the stock market’s valuation of the entire company.
Share Price and Price to Earnings Ratios
Share price alone is arbitrary. Shares of Stock A trading at $50 are not exactly more “expensive” than competing shares of Stock B at $25. The $1000 investment is still a $1,000 investment at 20 shares of Stock A or 40 shares of Stock B. Investors must appreciate corporate structure and the basics of financial statements to determine value.
Corporations issue stock to raise capital, which is backed by the earnings of the firm. Alone, pricing and the numbers of shares issued are meaningless figures, without standards to measure assets, liabilities, equity and net income above all else.
Price to earnings (P/E) is the most basic ratio of value. The P/E is calculated by dividing the current share price by the earnings per share (EPS) of the corporation. Accountants divide the net income of the entire company by the number of shares outstanding to arrive at EPS.
Book value, also described as net worth or equity, and is defined by subtracting the corporation’s liabilities from its assets. Again, investors will divide shareholder equity by the number of shares outstanding to arrive at book value per share. Publicly traded stocks that may be bought for less than book value may be described as “cheap.”
Whereas book value signals what is “in” the corporation, intrinsic value describes what can be taken “out” of the business in terms of future earnings. Intrinsic value is the present value of future earnings reinvested at prevailing interest rates. The discounted cash flow formula is [EPS x (1 + Long Term Growth Rate)] / (Discount Rate – Long Term Growth Rate).
Growth rates are integrated as decimals. Meaning, three percent is .03.
Onyx considers stocks that trade for less than intrinsic value to be cheap, value plays.