Investing Series: Ratios – Calculating Fair Value or Book Value of a Company
This is a part of the Investing Series.
This calculation of “multiples” of a stock price, are also sometimes called “technical analyses”, because there are hard numbers associated with it.
Other analyses that are not as technical, include the “gut feeling” analyses, and “speculative” analyses, where you think a company MIGHT go up in value, and/or grow in ways that are not easily seen by the market.
You don’t REALLY need to do any of these calculations because you can just go to Google Finance or Yahoo Finance and look at what they’ve done for American stocks (they tend to be fairly accurate), however if you’re looking for Canadian companies, you might have to do a bit of digging because we aren’t as organized.
WHAT ARE SOME COMMON THINGS (a.k.a. MULTIPLES) WE CAN USE TO EVALUATE STOCKS?
As I mentioned above, calculating some ratios or multiples to use in an analysis on what a stock is worth, is the first step once you zero in on a stock you like.
Here are 3 very common ratios that I will go into detail:
(I will try to add more as the series goes on..)
- Fair Value of a Company
- Price to Earnings
- Price to Book
There are plenty more than just the above, but those are the main ones that people use, and luckily, you can simply use Google Finance or Yahoo Finance and you’ll get these ratios on pretty much any American company that’s trading on the stock market.
Canadians, may have to do a bit of work, because we don’t have the kind of breadth of financial coverage as the Americans do.
FAIR VALUE VS. BOOK VALUE VS. MARKET VALUE
All of the above just takes into account how much the company is worth.
Before we continue, we should talk about what all these values mean.
- FAIR VALUE = Book value of the company (tangible assets) + Intangible Assets
- BOOK VALUE = Tangible Assets only
- MARKET VALUE = The stock price on the market today
WHAT ARE TANGIBLE VERSUS INTANGIBLE ASSETS?
Tangible assets are things you can physically sell.
Think of it like what you own — you have a car, books, a camera, a laptop, and clothes. You could sell all of that, all your TANGIBLE items, to make money.
Intangible assets are things you can’t physically touch, but can sell.
Think of it like your brain, or your reputation for being an excellent worker. You can’t physically take out your brain and sell it, but you could sell your services or your reputation for being an honest, great person to work with which would then make you money. These are your INTANGIBLE assets.
A company works in the same way.
What is “book” value versus “market” value?
Normally, book value refers to what you bought a stock at, and market value is what the stock is currently worth and what you could sell the stock for, today.
In companies however, book value calculations mean something slightly different, as in the physical tangible assets of the company divided by the shares outstanding.
It can be confusing when you hear “book value” to know what it means, but in the context of investing, you should know if it’s referring to the stocks you hold, or the company’s value.
In regards to stocks you hold (or your investments in general), most people focus on market value, because book value is only interesting if you want to figure out the profit of how much you made or lost.
Take for instance a bike as an example.
A Chinese “car” 🙂
Let’s say you bought it brand new at $5000.
The book value at the time you bought it, is $5000.
However, after 3 years, the depreciation against the bike (“wear and tear”), has chopped that book value in half to $2500.
The new market value of the bike and how much you could sell it to a friend today, is $2500.
It doesn’t matter what you bought the bike at in the beginning, because if the market dictates that it’s only worth 50% of what it was before, then it’s only worth 50%.
Stocks work the same way in your portfolio. You buy something for $5, it drops in value to $1, you lost $4 in value, and it’s worth $4 less than your book value, with $1 as your market value.
So what’s “BOOK” value of a company then?
It’s simply all the TANGIBLE assets of a company, such as their furniture, vehicles, land, factory, equipment, tools and so on.
This is not very handy in companies that deal with intangibles like services (consulting, technology, etc), because there are no actual “tangible assets” of the company, as the assets are their people and their brains.
Book value is handy for manufacturing companies, and less so for tech ones for instance.
You can value a company by its hard assets in a factory, less so in a technology or consulting-oriented one.
So what is “FAIR” value of a company then?
It takes the same idea of above, but it figures out how much a company is worth today on paper (on its balance sheets), and divides it by the number of shares it has issued so far.
.. but unlike BOOK value, FAIR value takes into account tangible AND intangible assets.
So let’s say that with a car, you bought the car as one of the 4 shareholders of the car and you each paid $5000 of the original $20,000 value.
Your brother, sister, and cousin have the other three-quarters of the car’s share.
Today, let’s say you all wanted to sell the car to a friend you all know.
Your friend would look at what the car is worth today ($10,000) at market value, and then (presumably) give you that amount of money for the car, plus a little extra ($1000) because he considers you friends and knows you took really good care of the car and trusts your goodwill / reputation as being honest sellers.
He pays you all a total of: $11,000 because he knows he won’t run into trouble with the car turning into a lemon after he drives it for a week.
You would each then receive $2750, as one of the 4 shareholders of the car.
(Maybe not THIS car for $11,000 but you get the idea.)
The original book value is $20,000 (tangible asset, you paid $20K for before)
The current market value is $10,000 (tangible asset after depreciation)
The fair value is $11,000 (tangible asset plus goodwill for being great caretakers)
DOING THE CALCULATIONS FOR BOOK AND FAIR VALUE OF A COMPANY:
If we want a real-live example of a company’s net worth or book value, here’s one we can look at:
This company had the following assets and liabilities; if it were a human, we could call it its “net worth”:
- $9.5 billion in tangible assets (its physical assets like its land, or the office furniture)
- $3.1 billion in intangible assets (its goodwill or its reputation)
- $3.3 billion in total liabilities (how much it owes)
- 524 million shares outstanding (how many shares it has sold on the market)
If we look at the calculations for BOOK VALUE:
$9.5B (Tangible Assets) – $3.3B (Liabilities) = $6.2B in tangible book value or net worth
$6.2 billion / 524 million shares = $11.83 per share in tangible BOOK VALUE
This means that if we just took their physical assets, the company is literally at the core of its parts, worth $11.83 per share.
If we look at calculations for its FAIR VALUE:
$9.5B (Tangible Assets) + $3.1B (Intangible Assets) – $3.3B (Liabilities) = $9.3B
$9.3 billion / 524 million shares = $17.75 per share in tangible and intangible FAIR VALUE
This means if we took their physical (tangible) assets and its intangible assets such as its reputation or goodwill, it is worth $17.75 per share.
How can you even count “intangible” assets in a company?
It sounds like Fair Value just overvalues the company right?
Well, for one thing, a brand has a reputation or a name, and this name is worth something.
(What it’s worth, is up for debate, but there’s no denying that it’s worth something.)
Take for instance McDonald’s or Coca-Cola.
Everyone knows their name all over the world, and if you were to sell that company, that reputation and brand recognition is worth something because it’s been built over the years and is globally recognizable, compared to some upstart company that might also sell fast food or soft drinks but would not be as well-recognized.
People will pay for that brand name and it’s worth something.
For another thing, intangible assets also includes things like PATENTS.
Many technology companies, are more intangible than tangible in terms of assets, so if you were to run P/B ratios on them that only looked at their hard assets, they’d look horribly overvalued.
P/B works best (in my opinion) for manufacturing companies that have factories and actual, physical assets that they need to produce things.
It’s not so hot for service industries (consulting) where it’s intangible assets like reputation, name or goodwill, or technology industries where it’s full of assets like patents, reputation and goodwill.
DON’T ASSUME ALL OF THIS IS ALL BLACK AND WHITE EITHER
Fair warning, it’s a bit of a guessing game with multiples.
You may have to also adjust and account for the fact that a company has a riskier profile than its competitors because it is poised for some serious growth.
Or that a company is about to go bankrupt, which is why it looks like such a bargain compared to its rivals.
It’s a lot like trying to figure out what the right price for a house is.
Your real estate agent might take houses that sold in the area with similar properties such as the number of bedrooms, whether there’s parking, or public transportation nearby, and then take an average (or a weighted average) of those sale prices to figure out what the right price for YOUR house is.
Maybe you have a pool and no one else does!
That could be a major selling point, and be an $20,000 extra on your list price.
Stocks are exactly like that — it’s all in relation to one another with exactly the same as anchor pricing cues to boot.
When you see something at $1.00, you can’t imagine paying $100 for it because the pricing cue is $1.00.
Yet when you see something at $1000, you think that anything at $25 must be a rip off because the pricing cue set in your brain, thinks that $1000 is normal.
- No one has the secret formula to become filthy rich
- It takes time to calculate multiples for a “technical” view, but it’s also a guessing game
- There are many ratios that you can calculate — it’s all up to you which ones to pick
- Tangible assets are things you can physically sell — factory, vehicles, land, machines
- Intangible assets are things you can’t physically touch but can sell — brand names, reputation
- Pricing cues are in effect when it comes to stock pricing