What's the retail value of your stocks?

If you’re shopping around for a new or used car it’s good to know the retail value of the vehicle so you’ll know if you’re getting a good deal or paying too much.  Wouldn’t it be nice to know the retail value of your stocks?  Some people think this number is the market capitalization, or the number of shares outstanding times the stock price, but this doesn’t take into consideration a company’s debt or its available cash.  A better way to gauge the price of a stock is too ignore the hype around a company’s stock price and focus on the company’s underlying value, or the Enterprise Value.

Enterprise Value is what you would pay if you were taking over a company. It’s the equity value of the company + the market value of its debt + minority interest (if applicable) – the market value of associate companies + the market value of preferred equity – cash and cash equivalents.

Equity value includes all ownership interest including unexercised stock options and is different from market capitalization (market value) which only reflects outstanding common shares. In a nutshell if you were going to buy an entire company you would pay the book value of the company, assume all the debt, pay off everone who invested in the company, and pocket the cash.

You wouldn’t pay for the portions of other companies the company has ownership in although they would roll over onto your new balance sheet and you would include any dividends on the income statement.

EV/EBITDA (earnings before income tax, depreciation, and amortization) is also called the Enterprise Multiple and gives potential buyers an idea of how long it would take for the investment to pay for itself. It’s a better ratio for determining likely takeovers because it eliminates taxation from the equation but includes debt, and a company with a low enterprise multiple would be a likely takeover candidate because debt is in the numerator and earnings is in the denominator, and a lower number should mean less debt, more earnings, and a relatively low market value.

The P/E ratio (also called earnings multiple) takes into consideration demand for company’s stock whereas enterprise value considers the company’s actual value. The P/E ratio compares the ratio of the company’s current stock price to the company’s earnings per share, or the net income of a company for the past 12 months and is also referred to as the trailing P/E.  The P/E ratio will increase as the company’s stock price rises and earnings hold steady, or if the earnings decrease.  If you substitute the past net income for the estimated net earnings for the next 12 months you would get the forward P/E. Neither of these numbers is useful without having something to compare it to, so you’ll need to know the P/E ratios of similar companies in the same industry to get an idea of whether or not the earnings multiple is high or low.

My opinion is the P/E ratio is given a lot more credence than it should; I don’t like that it compares the current stock price with past earnings.  This doesn’t seem to be a useful indicator of a company’s future price since it is comparing the value of the company’s current stock price to its earnings from as much as 12 months ago.  I’m always amazed at the number of “experts” who declare a company is overvalued because its P/E ratio is higher than its competition, regardless of how a company’s stock price is currently performing.  My hope is you will take the time to look at a company’s true value before you dismiss its stock as not worthy of investing in, and if you have any questions as to how to do this please take the time to email me your questions.

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You might also like to read:

1. How to analyze stocks like a pro
2. How to analyze stocks like a pro – part 5
3. How to analyze stocks like a pro – part 3
4. How to analyze stocks like a pro – part 4
5. 6 stocks for this economy