Asset based stock valuation
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
Valuing a stock or a company is not a particularly straightforward process and should not be viewed just as a process of number crunching. To be sure, numbers by themselves are exact but the outcome of the valuation process is not as simple as solving an equation. There are a large number of subjective factors to be considered in choosing the tools and making realistic assumptions. In this sense, stock or corporate valuation is more akin to art than science. Nevertheless, if you keep the limitations of these techniques in mind, they can still be useful in guiding you to make the right investment decisions. Moreover much will depend on the purpose for which the valuation is being carried out so the context of the valuation is important in the choice of techniques.
The first set of techniques are asset-based of which the simplest is to calculate the book value of the company which is also known as net worth or net asset value. This is simply the difference between what the company owns and what the company owes and includes all tangible assets such as plant and machinery or receivables and all intangible assets such as patents and trademarks. In other words, it would be what the company would be worth it if it stopped operations immediately and all assets can be sold at the values on the balance sheet. For instance, the great investor Benjamin Graham was interested in companies with large cash holdings which represented a large percentage of the market value. He reckoned that the companies that are cash-rich makes an excellent investments because of their ability to fund product development and business growth and provide handsome compensation to the managers.
Another form of asset-based valuation is to calculate the company’s working capital as the ratio of its market value. Working capital is calculated by reducing the current liabilities from the current assets and represents the resources that the company can use for its day-to-day operations. If you can buy a company at a value that is close to the working capital, you are acquiring one dollar worth of assets in return for one dollar in cash and this is not a bad deal. It also ensures that you are not overpaying for the stock.
Book value gets its name from the fact that it is a valuation that is based entirely on the figures on the balance sheet and the books of accounts. You can calculate the book value per share by taking the total shareholders equity or net worth and divide it by the number of outstanding shares. If you take the current market price and divide it by the book value per share, you will arrive at what is known as the Price/Book ratio. Obviously, the closer the ratio is to 1, the better the stock is for investment. However, you should bear in mind that the management has plenty of room for manipulation in the valuation of assets such as inventories and work in progress and balance sheet figures should not be taken as gospel truth.
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