Stock Valuation – How To Value A Company

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Stock Valuation – The Relationship Between A Company’s Stock Price and Cash

In another article titled Companies To Invest In, I made the point that, at its core, a well-run company is simply a money making machine. That concept – that the value of a company is ultimately tied to cash – is one of the keys to understanding how to value a company and it’s relationship stock price. Stock valuation are great to get quick snapshot of a company’s value. I’ll illustrate this point with a simple example, and then build on it in ensuing articles.

How To Value A Company – Cash Per Share Example 1

If there were a company that had $1,000 in cash with 100 shares of stock outstanding then you could calculate the value of each share of stock as follows.

How To Value A Company – Acquiring 20% Ownership Example 2

If that were the case and you wanted to own 20% of the company then how much stock would you have to buy, and how much would it cost? The answer is that you would have to pay a total of $200 for 20 shares of stock, which can be calculated as follows.

How To Value A Company – 10:1 Stock Split Example 3

What if the company did a 10 for 1 stock split, meaning instead of having 100 shares outstanding, it had 1,000 shares outstanding? Would that change the value of the company? The answer is no. The company’s only asset is $1,000 of cash, and no amount of stock splitting (or combining) can change that. However, by doing a 10 for 1 stock split the value of each individual share is diluted, going from $10 to $1 per share. So in summary, a stock split affects the value of each share of stock, not the value of the company itself, which can be illustrated as follows.

Now, what if our little company went public and was traded on the New York Stock Exchange? Wow, that’s big time! Wouldn’t that would boost its stock price above the $1 it’s now trading at after the stock split? Not at all! The stock could be traded on the moon, and that still wouldn’t alter the fact that the total assets of the company are worth $1,000, making the value of each of those 1,000 shares equal to $1.

How To Value A Company Using The Terminal Valuation Method

But wait, isn’t just focusing on a company’s cash overly simplistic? After all, there’s no company of any size or consequence whose only asset is cash. While that may be true, at the end of the day, determining how to value a company is ultimately measured in money (or cash) – nothing else. This is known as the terminal value of a company.

The application of this concept is known as the Terminal Valuation Method. To illustrate how it works, say a company’s stock price is trading at a value that suggests the total worth of the company is $10,000,000.[1] How can you tell if this stock valuation is reasonable? One way to go about it is by to pretending that the company sold everything off: its inventory, furniture and fixtures, real property, and so on, until it converted all of its assets to cash. After going through exercise you estimate that upon liquidating all of its assets and settling all of its outstanding debts (or “liabilities”) that the company would end up with $4,000,000.

“It’s Important To Note Stock Valuation Can Vary Greatly Depending On A Number Of Factors Such As: Industry, Maturity Level of Company, Ect.”

What…$4,000,000? Didn’t we say that the value of the company’s stock suggested that it was worth $10,000,000? Does this mean that the company’s stock price is vastly over inflated relative to its true worth? Perhaps, but not necessarily. For example, aside from tangible assets (assets that you can touch) that could be converted into cash, an established company might have valuable intangible assets that would substantially contribute to its ability to make money: established business relationships, a highly skilled workforce, an efficient supply chain, secret formulas and patents, widely recognized brands and trademarks, etc. In short, there can be a lot more to the value of a company than just its “hard assets” such as cash, inventory, property, etc.

However (and this is a BIG however), if a company is being valued at $10,000,000 and yet it would only be worth $4,000,000 upon liquidation, there still has to be a financial explanation for where that remaining $6,000,000 of value is coming from. In other words, what is it about the company that makes it worth more than sum of its tangible assets? If there is a compelling story there – a story that explains how the company’s business prospects, activities and operations are worth an extra $6,000,000 – then the stock valuation of the company can be justified. If not then the company’s stock price is being pumped up by hype and hot air.

Summary

While it’s true that you cannot you cannot fully measure the value of a company based on its hard assets (cash, inventory, buildings, etc.), it’s also true that a company’s value is ultimately measured in dollars. That means when it comes to a company’s stock valuation, cash is king!

[1] This would be the case if, for example, a company’s stock was trading at $50 a share and there were 200,000 total shares outstanding ($50 x 200,000 shares = $10,000,000).

Companies To Invest In – 3 Principles To Follow

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Investing means giving up some of your money now with the expectation of getting even more money in return in the future. Did you catch that? Money. Investing is about money. The bottom line when it comes to investing in stock (or anything else for that matter) is that you want a company that can profitably convert its goods and/or services into cash, lots and lots of cash. Well, isn’t that incredibly obvious? You would think so, but when it comes to identifying companies to invest in, it can be oh so easy to take your eye off the ball. Following are 3 principles that can help you to avoid getting distracted and maintain an investment-oriented focus for deciding which companies to invest in.

3 Principles For Finding Companies To Invest In

Principle #1 – Don’t Confuse Investing With Donating to a Cause

When considering investing in a company’s stock it’s vitally important to distinguish between evaluating the company vs. considering the companies valuation. To evaluate a company means to consider its overall suitability as an investment and to otherwise determine whether you’re comfortable with it. In other words, I don’t ever recommend investing in a company if you have a problem with the kind of business they’re in, or the goods and services they produce. For example, if you think smoking is bad for society then by all means don’t invest in a cigarette company, no matter how well you might think the stock will perform. Having said that, once you’ve evaluated a company and determined that you don’t have any ethical or moral problems with its business, it’s then time to consider the valuation of the company, or how much it’s stock is actually worth in dollars.

“Find Companies To Invest In That You Don’t Have Any Ethical or Moral Problems With It’s Business”

This is an important concept, because people sometimes confuse investing with donating to a worthwhile cause. For example, if a company is pursuing green initiatives such as clean energy, there are certain people who will almost blindly pour money into it. Is that a wise or unwise use of money? It depends. If your intention is to “invest” in a clean energy company without a thorough analysis of its business prospects then you’re acting unwisely because remember, when investing, the question you’re asking is not whether a company can save the world, but whether they can bring their products to market and generate a pile of cash in the process. On the other hand, funding a clean energy company can be a good use of your money even though it may be years away from producing a commercially viable prototype if your primary intention is to help the environment and profit is an afterthought (or not a consideration at all).

In summary, when looking for companies to invest in I think we would all like to invest in companies that both benefit society and would make us a lot of money in the process, but the reality is that such investment opportunities are few and far between. In other words, most companies aren’t out there saving the world, but they’re not destroying it either. Instead, they’re usually somewhere in between, trying to make as much money as they reasonably can by selling their products and services within the confines of the law and their business practices. For that reason, my recommendation is that if you intend to use your money to donate to a cause that will help society then by all means do so, but temper your expectations of getting anything (or even nothing) in return. On the other hand, if your intention is to invest in a company’s stock with the expectation of a solid financial return, make sure to keep your focus on the profit generating aspects of the company.

Principle #2 – Investing is About More Than Products, Services and Technology

Again, investing is about making money; it’s not about products, services, or technological advances in and of themselves, no matter how groundbreaking, novel, beneficial or noteworthy they may be.[1] To illustrate, I was once doing onsite professional work at a company. During one visit I noticed that an employee had a yellow sticky affixed to their computer on which they had written the most popular, trendy dot.com companies of the day – companies whose stock had skyrocketed even though they had no proven profit-making business models. We talked for a minute and I said, “I noticed you’re a big fan of dot.com companies.” The person said yes, and that they were an enthusiastic investor in them, to which I said, “Aren’t you concerned about the high valuations of these companies, even though they’re not making money?” To that the person said, “It’s not about valuation, it’s about revolution.” Upon hearing that my immediate thought was, “SELL! Everybody sell your dot.com stocks now!”

Why my reaction? Because it became clear to me that the whole dot.com-induced investment mentality had become so enamored with the life-changing technologies bringing on the Information Age that it had become unhinged from financial reality. But like any other law, financial reality cannot be defied forever, and not that long afterwards the vast majority of the dot.com’s burned through the remainder of their cash and crashed in spectacular fashion, leaving only those companies that had focused on realistic, workable, and sustainable profit-generating activities (Amazon and eBay, for example). The lesson? Remember that investing is not-about the products, technology, or services of a company, but whether a company can covert its products, services, or technology into more money (profit) than it costs to generate those products, services or technology!

Principle #3 – Don’t Buy into the Hype (or sell due to a lack of it)

When deciding which companies to invest in you may begin to notice that companies can be hip one day with a high-flying stock price and fall out of favor the next leaving their stock in the tank. Does that make sense? Does the financial outlook of companies really rise and fall so quickly? While it is possible, in the short-term a company’s stock (and the market itself) can frequently be driven by a herd mentality. Warren Buffet has a great quote that summarizes this concept: “In the short run, the market’s a voting machine, and sometimes people vote very non-intelligently. In the long run, it’s a weighing machine, and the weight of business and how it does is what affects values over time.”

In other words, over the long haul investing isn’t a popularity contest. No, in the end investing is about substance (or “weight”), or how much profit a company can churn out over time. So don’t get caught up in the hype and buy into a company just because it’s the latest market darling (you’ll likely buy too high), and don’t abandon ship just because a company is getting beat up in the media for making an understandable mistake (you’ll likely sell too low). Instead, step back, get some perspective, consider the big picture, and base your investment decisions on a company’s medium and long-term profit potential.

Summary of Companies to Invest In

When you boil it all down, all well-run companies have at least one thing in common: they’re trying convert their goods, services, and/or technology into as much cash profit as they can in accordance with the law and their overall business principles. In other words, at their core, companies (or any other kind of investment) are capitalistic, profit-centered money-making machines. If you don’t remember that then I don’t think you can ever properly judge the actual monetary value of a company’s stock. So, to maintain that investor-oriented focus, keep the following 3 things in mind:

While reviewing companies to invest in don’t invest in companies that you have moral or ethical problems with, but don’t confuse investing (making money) with donating to a cause (benefiting society).
Investing is about more than products, services or technology; it’s about efficiently converting products, services and technology into cash.
Investing isn’t a popularity contest; it’s about substance in the form of profits.

[1] Also, don’t automatically dismiss as an investment opportunity what may on the surface appear to be mundane or “boring” company. Fortunes have been made in the garbage collection business, and Gillette has made billions by cranking out massive quantities of sharp little strips of steel called razor blades!

Actively Managed Funds vs. Index

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Index Funds Consistently Outperform Actively Managed Funds

A recent survey once again shows what has long been the case, that index mutual funds consistently outperform actively managed mutual funds (see below). So if that’s the case then why do so many people invest in actively managed funds?

5 Common Reasons People Fall For Actively Managed Funds

Reason #1 – Ignorance

Some people simply do not understand the long-term performance of index mutual funds handily beats that of actively managed mutual funds.

Reason #2 – Sales Efforts

Firms make much more money off of actively managed mutual funds, often 1%-2% of principle per year vs. 0.18%-0.25% for many index funds. As a result firms put relentless efforts behind selling actively managed funds (with great success!)

Reason #3 – Greed/Temptation

By definition you can’t beat the market if you’re in an index fund designed to mirror the market. What are you, some kind of wimp? And so people pour billions into actively managed funds only to see their returns lag year after year.

Investor Pride – This is a close cousin of “greed/temptation.” Here’s how the story goes. Yes, there are lots of lousy actively managed mutual funds out there, but by virtue of your penetrating insight you are smart enough to pick a fund that will beat the market…and that’s how the train wreck begins.

Reason #4 – Fund Manager Pride

So despite the sub-par performance of actively managed funds, show me one that doesn’t have a fund manager that thinks they can be the market every year. If you can find one then I would love to see what the marketing material looks like, “Invest with us – we guarantee we’ll charge you more and underperform relative to the market in the process!”

Reason #5 – Performance Chasing

Maybe you’ve had a reality check and realize if you’re like most regular you can’t consistently beat the market (but don’t worry, the pros can’t either). But wait, you don’t have to be smart enough to beat the market, right? You’ll just find some mutual fund rankings and pick the ones that performed the best last 1-3-5 years, right? That’s called performance chasing, which is another name for buying high and often selling low (instead of the other way around!).

Low Cost Index Funds are the Best Long-Term Investment Strategy

So what’s the solution? What’s a good investment strategy for regular people? Unless you’re able buy stock or another investment at an amount that’s comfortably below the market price (such as pre-IPO stock) then you’re best bet for the long-term is to invest in low-cost index funds (view Best Vanguard Funds for specific recommendations). It may not get you riches anytime soon but hey, slow and steady worked out pretty well for the tortoise!

Financial Resources For Improving Your Financial Situation

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Managing your funds well throughout these times is of utmost relevance. Individuals are having a hard time making ends consult the raising cost of products as well as the rising interest prices on home mortgage as well as vehicle findings- the honest truth that a number of companies, and economic titans at that, are either folding or minimizing workers. You can improve your financial situation greatly by using the right financial resources.

Much uncertainty waits for the air in today’s financial scene triggering the need for useful finance assistance not simply for huge financiers yet right to typical individual trying to endure the day-to-day grind. It would certainly seem like employing an individual economist to help you make likelihoods and ends of your present situation would certainly be pricey as well as can perhaps lower your readily available financial sources likewise even more down.

Financial Resources Suitable for Road to Your Economic Success:

First is investments. There is no warranty that you’ll generate cash from investments you make. Yet if you obtain the basic realities about saving as well as investing and also adhere to using with an intelligent plan, you should certainly manage to obtain economic security as well as safety and security for several years and also indulge in the benefits of handling your money.

No individual is birthed recognizing exactly how you could conserve or to invest. Every effective investor starts with the essentials. A few individuals might stumble into economic protection – a wealthy loved one might die, or a business may eliminate. For great deals of people nonetheless, the only technique to obtain financial protection is to conserve as well as invest over a lengthy amount of time.

Discover if there is any money that could be spent. If so, then consult with financial resources such as an investment broker to check out if precisely what you need to invest is worth the trip. If it is large as well as it is put appropriately, then perhaps there will certainly suffice to use towards your retirement.

When you obtain your entire ducks right, make sure your tax obligation lawyer or accountant realizes your complete monetary development. They can assist you much better plan for the future by recognizing where you go to the present moment. They can additionally supply you some terrific recommendations relating to the very best ways to proceed in your investments.

Time and again, individuals of also moderate means which begin the quest reach financial security and also all that it assures: buying a home, academic chances for their children, as well as a comfy retired life. If they could do it, so might you.

Savings & Budgeting

Second of all is making to get just your basic needs as well as save as much of your incomes as you can. Include your cost savings in your regular monthly budget strategy. It is likewise a good idea to examine your investing methods and also you will be able to check out where you need to make decreasing or you could possibly source for an additional income. If you use bank card, it is very important to manage your investing. They are hassle-free yet at the same time they can land you into a stack of monetary difficulty.

It is vital that you entirely realized just exactly how it works to make sure that you could utilize it appropriately. If you acknowledge that you could not have the discipline as well as you put on not would such as to carry cash around, you can go with a debit card. It functions merely like cash and has a limit relating to simply just how much you can invest.

Learning How to Invest in Stocks 101

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Regardless of how many Wall Street films you have seen in the past, stocks and shares is not an easy topic. Those who are searching online for resources on how to invest in stocks for beginners or with little money thinking that they will “certainly” become the next overnight millionaires should, first and foremost, receive a word of warning: Yes, some people can really get rich overnight playing with shares at the stock exchange market; however, but that happens once a blue moon. Every person willing to dip a toe in the world of stocks investment should, at the very least, get prepared first and —as if you were playing chess— think his moves twice beforehand to prevent regrets after.

That being said… How to invest in stocks?

First Things First: Get Informed

Before spending one penny in a stock market, the first thing you should do is to get informed. Let’s ask a few questions so you can ask yourself if you know the answers:

Do you know what a stock is, and how they are currently stored?
How many kinds of shares are there, and which of them you can buy?
Do you know what a stock broker is? Have you found any for yourself already?
Lastly, have you spoken with your accountant about the financial and tax consequences (if any) of becoming a stock investor?

If you do not know the answer to any of these questions, then please let me suggest you the following readings:

Investing articles on stocks and the stock market could be a reasonable starting point.
The Beginners’ Guide to Investing, by the American Securities and Exchange Commission can provide you a more specific introduction to the topic.
Investor’s glossary page can help you clear your doubts.
Lists of stock brokers such as this one by Nasdaq can help you find a reputable stock trader for your assets.

Learning How to Invest in Stocks

Next, choose how you will invest in stocks

Once you have covered the basics and feel better informed to start investing, you need to find out a way to do it suitable for yourself and for your money. There are many options and approaches for this, yet, for beginners, I like to keep things simple. Remember the goal is to make money, and that you have basically two ways to get it with stocks:

You either buy stocks to resell them after a short time.
You buy stocks to expect a profit sharing payment or resell them after a longer term.

In both cases, your goal will be to make more money from what you invested, a profit.

What are the best stocks to invest in?

The best stocks are on companies or markets you understand, so this answer will depend strongly in your background. Let’s try to make it clear with an example, anyway:

Let’s say someone offers us stocks from an ice-cream company… would you buy them? An uninformed person may go buy them just because “heard” those shares are “about to go up”, and that “it is the exact moment to buy them.” Someone who understands the ice-cream market, however, would pause for a moment and think: Ice-creams are mainly sold in summer. During the winter, their demand falls down. The wisest move would be to buy the stocks in winter, when demand is low and prices go down; and to sell them in spring or at the beginning of summer, when demand goes up and so do prices.

After learning how to invest in stocks, remember knowing the market you are about to invest in will help you get a better understanding of when to buy or sell your stocks.

Certainly, your stock broker should advise you about your investments too.