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 In the first article in this series - Stock Research Part I - we talked about identifying the types of companies that we are interested in owning. To solve this problem, we suggested owning companies that were in businesses that we understood. We also talked about owning "excellent" companies with expanding value.
Stock Price Research and Intrinsic Value
In this second addition of stock research, we will begin to talk about how to calculate the price we might be willing to pay for a share of stock in an excellent company. The first step is to examine the stock against a standard or benchmark. In this example, we're going to use the one year Treasury Bill rate - let's assume that this rate is around 2.2%.
Calculating Intrinsic Value
We'll examine our stock against this particular government bond because as an investor, you have options available to you. You have the opportunity to invest at a risk-free rate of 2.2% or place your money on a considerably riskier investment and hopefully realize higher returns. The value of a stock relative to government bonds is termed intrinsic value. Let's look at an example of how intrinsic value is calculated.
Example Calculation - Intrinsic Value
The 3M Company is a component of the Dow Jones Industrials. In 2006 it was trading around $70 / share with a 2006 earnings estimate of $4.48. Again using the benchmark of the government bond at 2.2%, we can estimate the intrinsic value of 3M Company as $4.48 / 0.022 = $203 / share. This calculated intrinsic value is far in excess of the $70 range in which 3M is currently trading.
Remember that the point of calculating intrinsic value is to compare this value for 3M to that of a government bond. With projected earnings of $4.48 and a share price of $70, 3M's return on investment (based on earnings) would be $4.48 / $70 or 6.4%, nearly three times the return you'd realize by holding a government bond.
Therefore, the intrinsic value of 3M would be nearly triple the current market price of its stock at $70, which compares favorably to our calculated value of $203 / share - it all makes sense and it should. We now know how to calculate a stock's intrinsic value.
Calculating Return on Equity
The next calculation we'll take a look at is the return on equity. The return on equity is calculated by taking net income and dividing it by stockholders' equity. This value is important to understand when conducting stock research because net income is the money that is left over after paying for all the expenses needed to run a company. Those expenses including cost of goods sold, selling general and administrative expenses, depreciation, interest expenses, and income taxes.
When all these expenses are subtracted from the revenues of the company we have net income. Net income is the money available to the shareholders of the company. In 2005, the 3M Company had net income of $3.2 billion. According to the company's 10-K filing, stockholders' equity was around $10.1 billion. Therefore for 2005, the return on equity is calculated as $3.2 billion / $10.1 billion = 31.7%.
Next Up is Earnings Stability
This is a good place to stop. So now we know how to calculate two financial measures for a company - intrinsic value relative to government bonds and return on equity. In the next article in this series on stock research, we will take a look at earnings stability and earnings growth. We're quickly working towards making projections of stock prices, and finally bringing all this information together in an example case study.
About the Author - Stock Research Part II
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