Fundamental analysis can be a critical component to successful trading systems. Traders should learn enough about the methodology, terminology, and key indicators to let them enter trades with greater confidence. Value Investing was popularized by such great investors as Benjamin Graham and Warren Buffet, and Graham’s book Security Analysis is still the one book anyone interested in learning how to value companies should read. Figuring out what the intrinsic, or “book”, value of a company is the place all value investors start when they are trying to determine if a stock is over or under priced.
The intrinsic value approach to the markets starts from two basic assumptions. First, that the intrinsic value of an asset can be different from its market price. And second, that even though these prices may diverge from time to time, the market price will eventually gravitate to its intrinsic value. If you believe these assumptions, your investment strategy is clear. Buy when prices are below intrinsic value and sell when the stock is overpriced.
This may work in the long run for buy and hold investors, but as John Keynes famously said, “ In the long-run we’re all dead.” It is true that individual stocks can remain overvalued for long periods of time, often for longer than option traders tend to hold their positions. But I still feel it makes sense to try and enter bullish positions on undervalued stocks and bearish positions on overvalued stocks rather than the other way around.
Calculating intrinsic value is as much art as science. There is no simple equation you can simply plug numbers into, and a full understanding of the process takes the good part of a career to acquire. There are many models that have been developed to help determine the value of a stock including dividend models, earnings models, and asset models. However, all the average investor should need is a basic understanding of the financial statements and what book value means for a company, and the first place to start is always the Balance Sheet.
The Balance Sheet is a blueprint that shows the financial framework of the business, and it is divided into three main sections:
- Assets: What the company owns.
- Liabilities: What the company owes.
- Shareholder's Equity: The "net worth" of the company.
If you were to think about this in terms of your personal finances, Assets are all the things you own, like your house, car, boat, furniture, stocks, and money in the bank. Liabilities are any loans you have outstanding, like your mortgage and credit cards. The difference between your assets and liabilities is your net worth, or what would be left if you sold all your stuff and paid off all of your debt. The two sides of the balance sheet must equal each other, and this fundamental equation will always hold true:
Assets = Liabilities + Shareholder's Equity
Getting the balance sheets for a company is easy. Sources for financial statements include all the major financial websites, and you can always order free annual reports and financial statements from a firm's investor-relations department. The best place to get this information is to log on to FreeEDGAR (at www.FreeEDGAR.com). This site contains up-to-date figures straight from the SEC, and they offer a free plug-in that allows you to download reports into directly into Excel spreadsheets for further analysis. Look for the 10-K (annual financials) or 10-Q (the most recent quarter). Since Balance Sheets usually only have two years of data, always try to get at least two or three other past reports, which will allow you to see meaningful trend information for comparison.
The key ratio we want to get when analyzing a company is Book Value per Share. This is calculated by dividing a company’s total net assets (assets minus liabilities) by the total number of shares outstanding. Depending on the accounting methods used and the age of the assets, this ratio will help you determine if a security is overpriced or under-priced. A stock selling at a price far below book value may indicate the security is under-priced.
When you hear the term “Book Value”, you should be aware that it actually has two different meanings in finance. Book value is always synonymous with shareholder's equity (Assets minus liabilities). But it is also an accounting term used to describe the value of individual assets on the Balance Sheet. These are recorded at their “book value” (which is their original cost minus any depreciation over the ownership period).
This dual use of book value can often cause confusion. In the first case, we are talking about the firm as a whole and referring to the excess of total assets over total liabilities (Shareholders’ equity). In the second case, it refers to the original cost of an asset adjusted for accumulated depreciation or amortization. To further complicate matters, the book value of an individual asset is not necessarily its actual market, but at least it does provide a baseline for what the company might be worth if it were liquidated.
The main idea here is that when valuing a firm, you need to look at what they own (assets) and then subtract what they owe (liabilities). This is what is meant when someone refers to the book value of the company, as opposed to just an individual asset.
The final ratio you will want to calculate is Price/Book Value. This is calculated by dividing the current market price of the stock by Book value/Share. Like all fundamental data, it is most useful when compared to other companies in the same industry. The lower the price-to-book value relative to the rest of the industry, the greater the stock's growth potential. Companies with lower Price/Book ratios may also have a greater likelihood of being bought out by a competitor.
Using book value as a determinant of stock price is not as useful as it was sixty years ago when Benjamin Graham wrote his books. Historically, a company's market capitalization was closely related to the replacement value of its physical assets. With growing use of derivatives and off-balance-sheet financing this link is no longer as strong as it once was. Further complicating the issue, the value of a firm today is not only tied to physical assets on the balance sheet, but increasingly to intangible assets: brands, patents, franchises, software, research and development, ideas, and expertise. And few firms try to measure the return on these intangible assets, and none that I know of publish a value for them.
The only time intangible assets appear on the Balance Sheet is if they are purchased from another party. Internally-generated intangible assets aren't recorded on the books at all. Analysts may try to value these intangible assets and bring them into their calculations, but I don’t usually try to do this myself. Rather, I just informally keep in mind the other things a company possess such as positive customer relations, brand loyalty, or anything that may give them greater-than-normal earnings power.
The main intangible asset you often find on the Balance Sheet of large companies is “goodwill”. Goodwill is the amount above "fair market value" that a firm paid for another company during an acquisition. Unfortunately, this simply lumps all the intangible assets of a company’s acquisitions into a single number. It’s not a big deal if goodwill is low, but something to consider for firms that go on an acquisition binge.
So how should goodwill affect your analysis? A large amount of goodwill could indicate a firm overpaid for acquisitions in the past. Carrying a lot of overvalued goodwill on the balance sheet will result in a low price-to-book ratio, leading you to incorrectly think it is a cheap stock. One way to get around this is to reduce a firm's shareholder's equity by the amount of intangible assets to get "tangible net worth."
This leads us right into how to get an intrinsic value for companies whose assets consist almost entirely of intangible assets. Examples would be Software, Biotech, and Internet firms that have very liquid options markets and are popular speculative investments. The answer is that book value for these companies is really meaningless. Unless you know something about a new product under development, betting on yet-to-be-invented wonder drugs or new untested markets is often little more than a roll of the dice. Not that you shouldn't feel free to take a chance at times, just don't bet your life savings on it.
That said, a fundamental read on these firms can determine if they will survive long enough to reap their possible future rewards. Bringing in the Income Statement and calculating their "burn rate" (a kind of negative EPS trend) let’s you see how fast they're using up their capital and see how they can last without an injection of fresh funds. Check that these types of companies are financed appropriately, which should be mostly by equity with only enough debt to cover hard assets like computers or equipment. You may find that you think the risk too large relative to the chance of a phenomenal windfall.
Understanding the value of a company is very useful information to consider when entering an option position. While Book Value may not be as reliable an indicator as it was in the past, it is still the easiest way to get a feel for the real value of a company. Comparing Book Value/Share to the current market price will at least give you a floor that the stock price is unlikely to fall below, while the Price/Book ratio gives you a meaningful way to compare companies, especially within the same industry.