“Stocks are cheap.” You hear it time and time again. Now you’re hearing it from me. But one thing I want to make very clear before you read this article is that stocks can be cheap, and still not go up in value.
The reality is that even when things are cheap, it doesn’t mean they’ll be worth more in the future. However, now more than ever, it’s easy to say that stocks are indeed cheap—even if they remain cheap for a very long time.
Basics of Business Valuation
You have to understand business valuation to see why stocks are cheaper than ever. Let’s run through some very basic financial ratios and models so that we can do a high-level analysis:
- Shareholder’s equity – Shareholders equity is equal to the assets of a company, minus liabilities. If a firm has $500 million in assets—property, plants, land, cash, for example—and $300 million in liabilities, then shareholders have equity worth $200 million.
- Return on Equity – Return on equity is a very basic financial ratio. To calculate the return on equity, you simply take the net income of a particular company, then divide it by shareholder’s equity. A company that posts earnings of $50 million against shareholder’s equity of $200 million would then have a return on equity (ROE) of 25%. $50 million divided by $200 million equals .25, or 25%.
- Price to Book – The price to book ratio is the value of the company’s current stock price divided by the amount of assets less intangible assets. Thus, a company with a per-share price of $40, and net assets of $20 per share would have a price to book ratio of 2:1.
Business Valuation Mathematics
Let’s do some quick and dirty valuations for the largest 500 securities on the stock market—the total S&P500 index.
I pulled the following data from spdr.com, the ETF issuer for the popular S&P500 ETF SPY:
- Price to book: 1.89
- Return on Equity: 27.59%
This tells us a lot about the S&P500 index as a whole:
- Price to book indicates that if you were to buy the SPY ETF (all 500 stocks in the SP500 index) you’d pay just under two times the value of the assets. For example, if the average company is worth $50 billion, then it has $25 billion more assets than it has liabilities.
- Return on Equity – Return on equity tells us that for every $1 in book value, the S&P 500 index generates 27.6 cents in profits.
Let’s do some math
Return on equity and price to book are very much related. Price to book is a measure of the share price to net assets, much like return on equity is a ratio of profit to book value.
Thus, if we take the return on equity of 27.59% and divide it by the price to book of 1.9, we find a return of 14.2%.
We can also see that we have plenty of so-called “margin of safety.” Since we’re paying only 1.9 times the net assets of each firm, our companies have a breakup value of roughly half of every dollar we put in. Think of it like your first car. Mine was a piece of junk, but it couldn’t lose a lot of value, or any, for that matter. I could have always parted it for roughly the same value. You can part the 500 companies in the S&P500 index for half their total market cap.
Stocks go up, down, and all over the place in between the events that actually matter: buyouts. In a buyout, a company has to pay a fair market price for the company, not the stock, which is why you have buyouts that come in so grossly over the current stock price.
Let’s say you’re a S&P500 component and you want to buy another S&500 component. You can borrow money for 10 years for only 4%. Now, reference back to our ROE/P/B ratio and you’ll soon realize that the spread between corporate borrowing costs and returns in a buyout are spectacular! If you can borrow money at 4% to invest in a company that generates 14.2% returns, then you’re doing really, really, well.
Companies are cheap
Without going too heavy into this, or making things so simple that I join the leagues of Dave Ramsey, companies are cheap. Price to book ratios at 1.9 means that the S&P500 index at 1146 is essentially $603 worth of assets, and $543 worth of “company premium.” (I made that term up.)
With a return on equity of 27%, and p/b ratios at 1.9, any dollar invested into the S&P500 index today nets you $.142 per year in earnings. In buying out a company at the current share price, you’d be rolling in profits.
As for now, it’s just a waiting game. Seeing as most investors don’t have the kind of cash to finance a purchase of one of the largest publicly-traded companies in the US, investors will have to wait for cash to trickle down in the form of dividends, or, in the best case scenario, a buyout.
Even still, I like the numbers. Stocks are cheap.