If you were to look at a lot of companies and their stock prices, you could often conclude that the balance sheet does not seem important at all. I’ve mentioned before that there are numerous companies that sport a healthy stock price while also carrying a negative tangible book value per share. In such cases, future expected earnings must uphold the stock prices because no case can be made from the balance sheets that solid underlying equity support exists.
I’ve made this point before in both my book and blog posts, but I believe it is of critical import and worthy of repeating. There is no doubt about it; future earnings will drive the future stock price. However, if I base a buying decision solely on future expected earnings, how then am I assessing the risk to the amount of my initial investment?
Let me give an oversimplified illustration to make the point of this post. Let’s say, I want to make ten percent on my money next year. If a company tells me it expects to make $1 dollar per share next year, then, intuitively, it would follow that it should appeal to me for a $10 per share price tag today ($1eps/$10share price = 10%). Now, if I buy the share today and the company actually makes $.25 per share during the next year, the same rationale would suggest that I should have only paid $2.50 for the share ($.25eps/$2.50share price = 10%). That is, to achieve $.25, I would only have been willing to pay $2.50 to satisfy my ten percent required rate of return. I certainly would not have been willing to pay $10 under this notion of basing value solely on future earnings. To make $.25 on a $10 invested amount would only equate a return of 2.5 percent ($.25eps/$10share price = 2.5%).
The thing about future earnings is that they are uncertain. Uncertainty is synonymous with risk. So, how do I work to avoid the potential catastrophe of seeing a stock I paid $10 for suddenly plummet to $2.50 when the earnings per share disappoint severely per my example? Is this not a relevant and essential question to face before risking capital?
The theme of my book, “Choose Stocks Wisely,” is to emphasize the purposed role of the balance sheet to offer a basis for attaining an underlying value to a share of stock “aside” from the future earnings such that the dependency on future earnings outcome is not nearly as heavy.
Earnings will inevitably impact the stock price of companies across the board. When the outlook for earnings delights investors, the stock price reaction is usually very favorable and vice versa. To have the prospect of benefitting stock-price-wise from the potential upside when favorable earnings occur while avoiding being decimated when the earnings displease, there has to be ample balance sheet value supporting the price paid for the stock in the first place.
When there’s a lot of equity support behind the stock price I’ve paid, there’s at least a substantive reason for expecting a much better chance of price recovery after earnings disappointment than when the balance sheet offers a lack of underlying equity support. Equity is what the company has “already banked” and I don’t want to buy a stock that does not have adequate equity banked to help protect my purchase price.