The first article in this series explained how to identify the types of companies that are worth owning. This included companies that were in businesses that are understood as well as owning "excellent" companies with expanding value.
In this article, 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. This involves examining the stock versus a standard or benchmark investment. To facilitate that discussion, we're going to use the one year U.S. Treasury Bill rate and assume this rate is around 2.2%.
We'll examine our stock performance against this particular government bond because as investors we have options. For example, we have the opportunity to invest at a risk-free rate of 2.2%, or place our money in a considerably riskier investment and hopefully realize higher returns. The value of a stock relative to a risk-free investment, such as U.S. government bonds, is termed intrinsic value. The formula for intrinsic value can be stated as:
Intrinsic Value = Earnings per Share / Risk Free Interest Rate
Let's look at an example of how this value is calculated.
The 3M Company is a component of the Dow Jones Industrials. In 2006, its common stock was trading around $70 per share, with a 2006 earnings estimate of $4.48. Using the benchmark of the U.S. government bond at 2.2%, we can estimate the intrinsic value of 3M Company as $4.48 / 0.022, or $203 per share. This calculated intrinsic value is far in excess of the $70 range in which 3M was trading.
The point of calculating intrinsic value is to compare 3M's return to that of a risk-free investment. 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%, which is nearly three times the return of a government bond.
This means the intrinsic value of 3M would be nearly triple the current market price of its stock at $70. This sanity check compares favorably to our calculated value of $203 per share. We've developed an intrinsic value calculator to help work through additional examples.
Return on Equity = Net Income / Stockholder's Equity
This value is important to understand because net income is the money left over after paying for all the expenses needed to run a company has been subtracted from revenues. Those expenses include cost of goods sold, selling general and administrative expenses, depreciation, interest expenses, and income taxes.
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, or 31.7%.
We now know how to calculate two important financial measures for a company: intrinsic value relative to a risk-free investment, and return on equity. In the third article in this series, we're going to learn how to evaluate a company's earnings stability and projected growth rate.
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