Most stock market participants don’t give much attention to the equity of a company, found on its balance sheet, when it comes to setting a value for the company through the present stock price. This is amazing to me since a share of stock represents a share of company equity.

I can name a slew of companies that today have large negative equity numbers on their balance sheets and yet sport lofty stock prices. If I’m going to buy a share of balance sheet equity (known as Stockholders’ Equity), why would I be willing to pay a lofty ticket price for the stock when the balance sheet is void of any recorded equity?

The prevalent answer would go this way: I’m buying a stock today for the future earnings the company may produce, rather than the equity the business has already built. So, if the stock trades today for $10 per share and the company is expected to earn $1 per share (earnings per share) next year and grow earnings at a ten percent annual clip into future years, it’s worth the $10 ticket price today because I’m happy with a ten percent return on my investment.

Okay, but what’s the investment worth if the company makes less than the $1 per share or if the earnings don’t sustain a ten percent return by continuing to ramp up at that annual rate in future years? Well, if it was only worth a $10 share price if it could achieve a ten percent return, then it would have to be worth something less than the $10 now.

Of course, this is where the balance sheet equity comes in since it can establish some value for the stock price aside from the future earnings outcome. Look at the balance sheet equity from the angle of a banker thinking about making the company a loan. The creditor wants to know what collateral the company has available to help secure the loan should the company’s future not play out in a manner beneficial to the lender’s position.

Like the lender, I want to know there’s some collateral behind the price I pay for a stock. How much equity am I getting for my dollar?  What’s the quality of that equity? These two questions are essential to answer from my point of view. Central to the purpose of my book, “Choose Stocks Wisely,” is the attempt to address these two questions thoroughly.