Understanding Different Types of Value in Stock Investing - dummies

Understanding Different Types of Value in Stock Investing

By Paul Mladjenovic

Value may seem like a murky or subjective term, but it’s the essence of good stock-picking. You can measure value in different ways, so you need to know the differences and understand the impact that value has on your investment decisions.

Market value

When you hear someone quoting a stock at $47 per share, that price reflects the stock’s market value. The total market valuation of a company’s stock is also referred to as its market cap or market capitalization. How do you determine a company’s market cap? With the following simple formula:

Market capitalization equals Share price multiplied by Number of shares outstanding

If Bolshevik Corp.’s stock is $35 per share and it has 10 million shares outstanding (or shares available for purchase), its market cap is $350 million. Granted, $350 million may sound like a lot of money, but Bolshevik Corp. is considered a small cap stock.

Who sets the market value of stock? The market, of course! Millions of investors buying and selling directly and through intermediaries such as mutual funds determine the market value of any particular stock. If the market perceives that the company is desirable, investor demand for the company’s stock pushes up the share price.

The problem with market valuation is that it’s not always a good indicator of a good investment. In recent years, plenty of companies have had astronomical market values, yet they’ve proven to be very risky investments.

For example, think about Twitter (symbol TWTR). In February 2014, its stock price was more than $67 per share. It had lots of debt and generated losses during 2014 and 2015. By January 2016, its stock price had plummeted to about $17 per share (a 75 percent plunge, erasing billions in market cap), and it still wasn’t generating a profit. Yikes! Because market value is a direct result of buying and selling by stock investors, it can be a fleeting thing. This precariousness is why investors must understand the company behind the stock price.

Book value and intrinsic value

Book value (also referred to as accounting value) looks at a company from a balance sheet perspective (assets minus liabilities equals net worth, or stockholders’ equity). It’s a way of judging a firm by its net worth to see whether the stock’s market value is reasonable compared to the company’s intrinsic value. Intrinsic value is tied to what the market price of a company’s assets — both tangible (such as equipment) and intangible (such as patents) — would be if they were sold.

Generally, market value tends to be higher than book value. If market value is substantially higher than book value, the value investor becomes more reluctant to buy that particular stock because it’s overvalued. The closer the stock’s market capitalization is to the book value, the safer the investment.

You may want to be cautious with a stock whose market value is more than twice its book value. If the market value is $1 billion or more and the book value is $500 million or less, that’s a good indicator that the business may be overvalued, or valued at a higher price than its book value and ability to generate a profit. Just understand that the farther the market value is from the company’s book value, the more you’ll pay for the company’s real potential value. And the more you pay for the company’s real value, the greater the risk that the company’s market value (the stock price, that is) can decrease.

Sales value and earnings value

A company’s intrinsic value is directly tied to its ability to make money. For this reason, many analysts like to value stocks from the perspective of the company’s income statement. Two common barometers of value are expressed in ratios: the price to sales ratio (PSR) and the price-to-earnings (P/E) ratio. In both instances, the price is a reference to the company’s market value (as reflected in its share price). Sales and earnings are references to the firm’s ability to make money.

For investors, the general approach is clear. The closer the market value is to the company’s intrinsic value, the better. And, of course, if the market value is lower than the company’s intrinsic value, you have a potential bargain worthy of a closer look. Part of looking closer means examining the company’s income statement, also called the profit and loss statement, or simply the P&L. A low price to sales ratio is 1, a medium PSR is between 1 and 2, and a high PSR is 3 or higher.