Hey friends. My book, “Choose Stocks Wisely,” harps on the essential role of the balance sheet in proper risk assessment. Some things are worthy of harping. In my view, the balance sheet is what anchors good investment decisions. It details the nature of the assets you are buying at the time of your decision.
There are methods that value a stock investment based on discounting a future stream of dividends. Of course, the large number of non-dividend paying companies on the market would be deemed worthless by such an approach. Valuing a company based on modeling a future stream of earnings would leave many early-stage biotechnology companies high and dry as they will only burn cash for the foreseeable future. So, not all return-based valuation models universally work. But all companies do have a balance sheet and it exists universally to reveal how much equity there is, the nature of that equity, and thereby to communicate the current financial flexibility of the business with regard to accomplishing a future.
Just as one may shop a Certificate of Deposit for the best interest rate and choose according to the one with the best return potential, it indeed makes perfect sense to choose stock investments with an eye toward return potential. But valuation toward investing should never be exclusively based on the reward potential. There were people forced to seek reimbursement by the FDIC on money invested in CDs when several banks failed in 2008 including the stately Lehman Brothers. And, of course, with stock investments, if the company fails, there’s no FDIC to insure your loss of investment. Just as assessing the balance sheet of a bank holding your CD money is important, how much more important is it to assess money invested into company stock where there’s no guarantee of loss coverage?
The simple truth is I need to know the value of what I’m buying today “as is.” Otherwise, I’m risking losing my money. Only the balance sheet shows me what I’m buying. Higher quality assets are tangible and closer to being converted to cash — like high quality Accounts Receivable, for example. Does the future matter? Certainly! But so does the present. Neither can be ignored. It’s not all about the balance sheet and it’s not all about the return. You see, I don’t want to just buy a right to a future return; No, I want to also buy substance that exists right now. That substance gives me a form of insurance on my invested capital in case the future I’m hoping on fails to happen.
See you next time.
There is another issue with the discounted cash flow method of determining the intrinsic value of a stock and that is what to use as an appropriate rate of discount. A weighted average cost of capital estimate can change due to alterations in the risk free rate of interest and beta. Some analysts conveniently forget Richard Roll’s research showing that betas are not stable over time.
Thanks. That a great point. Many companies don’t reflect static capital structures either. There’s a lot of “art” to prediction. Without making full use of the balance sheet (which is an updated record of history — “what is”), one has to be all the more artistic.
Do analyst price targets hold any weight when determining the future growth prospects of a quality value stock selling below the tangible book value coupled with ample liquidity? I.e. a stock with a quality balance sheet has an analyst price target much higher than the current price. Would this be a factor of consideration in determine potential earnings growth? I notice that analyst price targets are somewhat correlated with forecasted eps. For example, many of the companies with poor future earnings estimates typically also have lower price targets. Conversely, companies with strong expected forecasted earnings have higher price targets. My assumption is that the analysts take more factors beyond earnings into account when developing a price target. This may make the research more thorough than a simple earnings estimate itself, as we know that forecasts are somewhat of a crapshoot. Of course, the stock must be well researched regarding its industry and prospects.
I would say analyst price targets are one factor and this factor is typically heavily based on projected annualized growth in earnings. Oftentimes, though, companies that trade below tangible book with ample liquidity are small companies without analyst coverage. Sources like Yahoo Finance, for example, will sometimes show analyst price targets that are the same as you would have seen years ago. In such cases, coverage likely ended years ago but Yahoo never updated its information. So, the source of analyst price target information should be verified. Tipranks is a source you might look at.
Now, if it’s an analyst toward an early-stage small biotechnology company, he/she is likely speculating on things like existing cash position, quarterly burn rates, and eventual peak sales potential based on probability analysis of the drug being developed becoming approved by the FDA and then becoming commercialized. So, as I’ve said before, it’s always hard to make generalized statements in stock valuation. That’s one thing reason I harp on the balance sheet; it doesn’t involve what is yet to be and it is a valuation tool that exists for every company, regardless of size or nature of business.
Most often where plausible, I believe, analysts do follow earnings models where they employ the projected annualized growth rate as a proxy for a fair value P/E. This follows after Lynch’s PEG (P/E to Growth) methodology. You can google Lynch and PEG ratio to read about this if you haven’t before. A PEG of 1 would say the P/E should be equal to the projected annualized earning growth rate. A PEG of 2 would suggest a P/E of 2 times the annualized growth rate and so on. Using PEG, a fair value price target is then set.