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401-Understanding Value
  Course 401:
  Understanding Value
  Investors often erroneously assume that a great company translates into a
  great investment. We discussed several ways to identify superior businesses,
  but we did not bring up valuation. Finding strong companies is crucial in the
  investment process, but it is equally important to determine what those
  companies' stocks are actually worth. Your goal as an investor should be to
  find wonderful businesses, and invest in them at reasonable prices. If you
  avoid confusing a great company with a great investment, you will already be
  ahead of many of your investing peers.
  
  Suppose you are buying a car. Before you make a purchase, you will probably
  want to do some research, identify a few promising candidates, and take each
  for a test-drive. But throughout the process, you will also be aware of price.
  After all, you would not pay $50,000 for a used clunker, though you might pay
  that much for a new luxury car. Likewise, you would probably never spend
  $200,000 on a car, no matter the make.
  
  The same thing should be true if you are thinking about buying a stock. A
  company's profitability, growth prospects, quality of management, and
  competitive advantages vis-a-vis its rivals are all important factors to
  consider. However, even the greatest company in the world might not be an
  attractive investment if its stock is priced too high. The price you pay for a
  stock can have a significant effect on your returns, and it can mean the
  difference between a good investment and a mediocre one. (Or worse!)
  
  
  Why Valuation Matters
  To illustrate the importance of valuation, consider the case of hypothetical
  investors Smith and Johnson. Johnson is a value investor who is always on the
  lookout for bargains, while Smith is of a different sort. Smith buys whatever
  is hot, regardless of valuation.
  
  On April 1, 1996, Johnson bought 100 shares of Dell DELL. At the time, lots of
  people had doubts about Dell's future. The stock had fallen 18% over the
  previous year, and it was trading relatively cheaply at a trailing P/E ratio
  of 13. Dell eventually turned things around, and its stock became one of the
  hottest in the late 1990s before falling back to earth along with the rest of
  the market. As of April 1, 2005, Johnson's investment was worth $38.03 a
  share, versus $1.19 a share on a split-adjusted basis when he bought it. That
  represents an annualized return of about 47% after nine years--not too shabby
  at all.
  
  On the other hand, Smith didn't care about Dell when it was cheap. He bought
  the stock on April 3, 2000, for $53.38 a share, when market sentiment was
  sky-high, and Dell had a trailing P/E of 88. That's pricey by nearly any
  measure, but Smith didn't care. He was excited about the stock's possibility
  and willing to pay any price for it. After all, who could argue with buying a
  stock that had tripled over the previous two years?
  
  In retrospect, we can see that Smith was buying at the peak of a market bubble
  that was just about to burst. As of April 1, 2005, Smith's investment had lost
  about 29% of its value, representing an annualized loss of 6.5% over five
  years, despite the fact that Dell as a company has continued growing quite
  nicely.  Maybe someday Dell's stock will eventually surpass what Smith
  originally paid for it, but Smith would have obviously been much better off
  had he taken a pass on Dell in April 2000.
  
  With 20/20 hindsight, it's easy to see that Dell was cheap in 1996 and
  expensive in 2000. In the real world of investing, we don't have the benefit
  of knowing exactly what is going to happen, but we can still make our best
  estimate as to whether a stock is cheap, reasonably priced, or too expensive.
  Making such estimates is arguably the most important determination of your
  investment success. In the next several lessons we'll introduce you to some of
  the ways you could try to determine what a stock is worth.
  
  
  Measuring Market Capitalization
  The first step to figuring out whether a stock is cheap or expensive is
  measuring the market value of a company. Unfortunately, the stock price you
  see in the newspaper or on your computer screen doesn't say anything about how
  much a stock is really worth. A $100 stock is not necessarily more expensive
  than a $10 stock, and it may be in fact cheaper.
  
  The most common way of measuring a company's value is market capitalization,
  or market cap for short. (To recap, the market cap of a company is the total
  market value of all the company's outstanding stock, representing the share
  price multiplied by the number of shares outstanding.)
  
  Market Cap = (Number of Shares Outstanding) x (Price of Each Share)
  
  Keeping the number of shares constant, a company's market cap will rise and
  fall with its share price. The market cap also represents the value the market
  places on the entire company. The companies with the largest market caps are
  all big, well-known names and by definition are among the most widely held
  stocks.
  
  It's worth noting that market cap measures only the market value of a
  company's equity, and you may remember that companies have access to two
  sources of capital: equity and debt.
  
  To get around this, investors commonly use a variant of market cap called
  enterprise value, which tries to measure the value of the actual business
  itself, stripping away purely financial elements. There are many flavors of
  enterprise value, but the most straightforward way to calculate it is market
  cap plus long-term debt, minus cash.
  
  Enterprise Value = (Market Cap) Debt - Cash
  
  Enterprise value measures how much it would cost someone to buy out all the
  owners of a company, pay off all the company's debts, and take out any cash
  that is left over. For example, as of April 1, 2005, General Electric's GE
  market cap was $375.9 billion, and ExxonMobil's XOM was $386.6 billion. GE had
  $213.2 billion in long-term debt and $15.3 billion in cash and equivalents,
  whereas Exxon had only $5.0 billion in long-term debt but $23.1 billion in
  cash and equivalents. Thus, Exxon's enterprise value was about $368.5 billion,
  while GE's was $573.8 billion--a significant difference.
  
  
  The Meaning of Stock Values
  At this point, it's important to remember that a stock's value is determined
  by the company's underlying performance. It's easy to think of Dell as just a
  number on a computer screen or a squiggly line on a chart, but the reason it
  has any value at all is that it is a business that is growing and generating
  profits. Thinking of a stock as a piece of a business will be particularly
  helpful in understanding many of the valuation methods we will be considering
  in the next lessons.
  
  There are actually two parts to the value of any business. The first part is
  the current value of all the business's assets and liabilities, including
  buildings, employees, inventories, and so forth. The second part is the value
  of the profits the business is expected to make in the future. Some companies
  get most of their value from the first part. These types of companies tend to
  be mature, stable businesses without a lot of growth prospects, such as
  utilities and real estate companies. For these firms, the assets are in place,
  and the future cash flow is relatively predictable.
  
  On the other hand, some companies get most of their value from expectations of
  future growth and profits. These types of companies tend to be younger with a
  lot of growth potential. Many biotechnology companies would be included in
  this category.
  
  Actual assets and liabilities are a lot easier to measure than hypothetical
  future profits. This is one reason stocks of younger companies tend to be more
  volatile than their more buttoned-down brethren. When expectations are high,
  the market anticipates that future profits will continue to increase, and it
  bids up the stock. When pessimism takes over, the market expects fewer profits
  in the future, and the stock price falls. Ultimately, estimating what a
  company will do in the future is the key to all forms of stock valuation.
  
  
  Two Approaches to Stock Valuation
  There are two broad approaches to stock valuation. One is the ratio-based
  approach and the other is the intrinsic value approach. We will be looking at
  both of these in more detail later, focusing on the intrinsic value approach
  that we tend to favor at Morningstar. But here's a brief overview to get you
  oriented.
  
  If you have ever talked about a P/E ratio, you've valued a stock using the
  ratio-based approach. Valuation ratios compare the company's market value with
  some financial aspect of its performance--earnings, sales, book value, cash
  flow, and so on. The ratio-based approach is the most commonly used method for
  valuing stocks, because ratios are easy to calculate and readily available.
  
  The downside is that making sense of valuation ratios requires quite a bit of
  context. A P/E ratio of 15 does not mean a whole lot unless you also know the
  P/E of the market as a whole, the P/Es of the company's main competitors, the
  company's historical P/Es, and similar information. A ratio that looks
  sky-high for one company might seem quite reasonable for another.
  
  The other major approach to valuation tries to estimate what a stock should
  intrinsically be worth. A stock's intrinsic value is based on projecting the
  company's future cash flows along with other factors, which we'll discuss in
  Lessons 403 and 404. You can compare this intrinsic or fair value with a
  stock's market price to determine whether the stock looks underpriced, fairly
  valued, or overpriced.
  
  The advantage of this approach is that the result is easy to understand and
  does not require as much context as valuation ratios. However, the main
  disadvantage is that estimating future cash flows and coming up with a fair
  value estimate requires a lot of time and effort. We think the advantages
  outweigh the disadvantages when this type of valuation is done carefully. That
  is why it forms the basis of Morningstar's fair value estimates and star
  ratings.
  
  
  The Bottom Line
  Finding great companies is only half the equation in picking stocks. Figuring
  out an appropriate price to pay is just as important to your investment
  success. A great company might not be a great investment if its stock is too
  expensive. Likewise, a company of mediocre quality could be a good investment
  if bought cheaply enough. Either way, it's critical to be aware of the prices
  you are paying for your stock investments.