Businessman Investor

Touching base with the rational business psyche of stock market investors

Monday, August 8, 2011

The Price-Value Breakeven Theory of Stock Investment

Introduction: In the early stages of my investing career, I tried to develop an independent way of thinking about stocks—my intention was to focus on the stock’s underlying business financials and utterly disregard how its price performed. The idea was to put myself in the shoes of a rational, long-term shareholder (and have the sort of pure mindset of an entrepreneur). The exercise led me to ponder on very basic but key financial concepts. Note that this is, admittedly, a very extreme, crude approach and wouldn’t seem practical. It has yet to consider cash flows and the time value of money. But I think it’s worth a review to touch base with our business mind or entrepreneurial psyche when dealing with stock investments...

From a purely business perspective, the moment you buy a stock, what you immediately possess as a part owner or stockholder of that business is its current net worth, its equity, or book value. In addition to its present net worth, you also possess its earnings potential which is realized in the future. Premium is therefore understandable, but not to such extent it already escapes rational potency of earnings. Overpricing risks permanent loss of capital.

Taking a feasibility and payback approach to stock investment, this valuation theory treats the buy price of a stock as an initial outlay. The investor, stoic to market price fluctuations upon entry, therefore, takes on the conservative position of eventually breaking even when book value per share, through comprehensive earnings and stock dilution/accretion gains, overtakes price. Upon breakeven, the investor’s rate of return approximates the Return on Equity (ROE).

The conservative investor might as well view three values in which a stock is judged: its book value, market price, and breakeven price—the first two already given and reported, and the lattermost being relative to the investor's opinion. We can think of sophisticated calculations of that concept called intrinsic value—we are of the opinion, however, of just eventually breaking-even on our paid-up market price through book value, the net worth, equity, or that part of the business which is owned by the stockholder. With this, it's as good as saying that upon breakeven, it's all gains and profits.

The Business Sense of Book Value

Now one might argue that what matters is the stock’s market price, and one would care less of the book value—if you are a trader whose gain horizon is of the short-term, I would agree. But we are in the business of capturing consistent gains. The market is mostly emotion, indeed, and is based on popular perception of a business—the trendy stock gets favorable gains not necessarily because by virtue of business, but because of popular belief which may or may not be based on sound fundamental grounding. Book value, on the other hand, is simply all about cumulative gains or losses—its growth, therefore, makes more business sense. If one is so conscious about reported earnings, the more so should be with net worth in which earnings are accumulated. Statistics dictates that since investors are willing to pay up a premium, market price mostly exceeds book value. Hence, book value establishes that base in which capital preservation is assured. That is to say, from a technical perspective, it is the definitive base line support to preserve capital, and guard against its permanent loss. A company consistently growing it surely is doing something right. Warren Buffett himself noted book value growth approximates intrinsic value growth—although we're more interested in estimating a breakeven buy price than the intrinsic value.

The Realistic Shortcomings of the PE Ratio and Earnings Yield

A lot of value investors have this tendency of relying on Price/Earnings (PE) Ratio for valuation enlightenment. Some would look at the reciprocal counterpart which is called the Earnings Yield (Earnings/Price). It's a quick and dirty method to see whether a stock is cheap or not. The usual rhetoric goes like this: if you bought a stock selling at PHP 100.00 and its earnings per share (EPS) is at 15, you just had a 15% rate of return. It does sound convincing, but did you really have 15% as your rate of return? The approach lost sight of what really is possessed upon acquisition of the stock. Because in reality, it's most likely that the PHP 15 EPS is already old news—it's the reported EPS last year. Realistically speaking, what good is it to determine your yield from earnings which has already been earned the moment you bought the stock? More so, if you say that you did have a rate of return that's 15%, then it's as good as saying your equity/capital now would be PHP 115. Is that really the case? We regret, but no. From a purely business perspective, the moment you bought the stock, what you presently possess as a part owner or stockholder of the business is its current net worth or book value. If the book value of the stock is actually at PHP 50.00 and you bought it at PHP 100.00, then right there and then, you lost PHP 50.00 (100 - 50). What a crap deal you might say. Yet as in all good investments, the reward is realized in the future. If that stock's book value is indeed at PHP 50 and it earned PHP 15, it had a return on equity (ROE) of 30%. Don't get too excited just yet because you still haven't realized that rate of return if you did purchase it at PHP 100. Here's the kicker: if that business historically maintains that level of ROE for say 6 to 10 years, then it surely must be doing something right, and it only demonstrates its superior business economics working in its favor. Assuming it retains the same level of ROE for the next coming years, just observe the compounding growth of net worth/book value and net income:

Book Value Growth (15% ROE)

  • Year 0: 50
  • Year 1: 65 = 50 x (1 + 15%)
  • Year 2: 84.50
  • Year 3: 109.85
  • Year 4: 142.81

Net Income Growth

  • Year 1: 15 = 50 x 15%
  • Year 2: 19.50
  • Year 3: 25.35
  • Year 4: 32.96

By the 3rd year, your purchase price of PHP 100 would already have been overtaken by your book value of PHP 109.85. At that stage, your rate of return equals ROE—a 30% rate of return continuously compounding, working for you, and making your wealth bigger regardless what the market says about the value of your stock. Now that is the kind of feasibility approach any businessman should consider—it gives a more realistic, business perspective on stock investing and sheds off emotion aside. Indeed, when the company earns, you really do have a share in those earnings.

Qualification of the ROE and ROA Formula

Conventional computation of Return on Equity (ROE) is Net Income/Average Stockholder’s Equity. Unfortunately, most interprets Average Stockholder’s Equity as the average of beginning and ending equity. The fault does not come from the beginning equity but from the ending which already possesses the net income which is supposed to have been the generated earnings for that period. We should remember that the purpose of ROE is to measure profitability or efficiency of equity to internally produce additional capital by virtue of business—any added capital externally sourced through IPO’s or stock options should be subject to the same test. The net income component—that which has been internally generated—of the ending equity, therefore, should be isolated. Just to stress and be more to the point, we further detail the ROE computation as Net Income/ ([Beginning Equity + (Ending Equity – Net Income)]/2). The same would apply to ROA, substituting Average Total Assets instead of Average Stockholder’s Equity.

Quality ROA assures Quality ROE

Despite the importance of ROE in measuring firm profitability to equity holders, it falls short of measuring efficiency of asset utilization. A firm which has a terrific ROE may not necessarily be a good business because it might be achieving it through debt or leverage. Added debt obviously means added risk of bankruptcy. But that is not to say that debt ought to be abhorred. It’s okay to take on some as long as the company is able to efficiently utilize them. Hence, instead of the tendency to have our attention jump immediately to ROE, it pays to investigate first Return on Assets (ROA). A rule of thumb would be: if its ROA performs well, then regardless of capital structure (debt or equity), one is assured of their efficient utilization which would imply lower risk of bankruptcy. We’d rather own a company which has a lower but above average ROE and a good ROA than a company which has an extraordinary ROE but a weak ROA. Quality ROA assures quality ROE.

The Cost of Premium and the Gain on Discount

Premium on what and discount on what? Convention points to book value. Upon stock purchase, it's most likely one pays up—that is to say, pays up a premium above book value. From a very conservative and pessimistic view, one loses value which is the difference between the paid price and the book value. Upon purchase below book value, however, one gets a discount, or eventually gains which is the difference between the book value and the discounted price. Hence, assuming that a company is already decided to be fundamentally sound, one gets a bargain at that kind of deal. A premium therefore has its cost. A discount, on the other hand, has its gain.

Book Value Growth as the Stockholder’s Value Growth

It’s easy to assume that growth of the business is attributed to earnings. Indeed—it is the only true growth by virtue of business. Yet we should not lose sight of other factors that contribute to value creation. Stock lingo is biased on the 'per share' concept. It's not that we don't favor this kind of bias, but that it's only necessary, useful, but demands a more careful approach on determining just and equitable division of value among shareholders. For other than the usual value enhancement/detriment factor known as the net income/loss, there is this phenomenon called dilution/accretion which the investor has to grasp and understand. Add to that other comprehensive income which is not stated in the income statement. The key question that should be asked, therefore, is: what increases/decreases the shareholder's net worth? Or to paraphrase: what are the causes of change in book value? To answer this question requires one to understand what composes book value, and the changes in each book value component.

Equity Breakdown:

  • Common Shares and Paid-in/up Capital – added equity externally sourced
  • Retained Earnings – equity component which accumulates all internally generated gains/losses
  • Treasury Stock – accumulates shares bought back at cost (this is a counter equity account and is negative)
  • Cumulative Translation Adjustments (CTA) – accumulates gain or losses from foreign exchange fluctuations
  • Available for Sale Investments (AFS) – cumulative gain or loss from the changes in price of equity/stock investments intended to be sold

We can identify changes in the book value:

  • Earnings/losses – this is the change in retained earnings by virtue of business
  • Dividends – a reduction in retained earnings; though some would argue that this is simply a transfer of value from the company to the investor and hence would have no net effect to value, we view it as a detriment since it exposes one to incur the cost of premium (i.e. reinvesting them in stocks and hence paying up again a premium), or lose its vested compounding power.
  • Share buy backs – change in the Treasury Stock (similar to dividends, we view it as detrimental as well since it incurs the cost of premium)
  • Other Comprehensive Income – these are the changes in CTA and AFS (note that these are immediately influenced by foreign exchange and stock market price fluctuations); they are not reported under the income statement primarily because these are yet to be realized.
  • Stock Dilution/Accretion – occurs because of the disproportionate percentage change in equity and outstanding shares

The Phenomenon of Stock Dilution/Accretion

Two kinds of dilution/accretion can be summarized from the following discussion—these are: stock or book value dilution/accretion and earnings dilution/accretion. Let’s observe the former through a demonstration:

Year 0

  • Equity = 100
  • Outstanding Shares = 100
  • Book Value = 1

The firm issued 10 shares at PHP 2.00 a share in Year 1.

Year 1

  • Additional Capital = 20 (PHP 2.00 x 10 shares)
  • Equity = 120 (100 Beginning Equity + 20 Additional Capital)
  • Outstanding Shares = 100
  • Book Value = 1.20

From the point of view of currently existing owners, their stock experienced accretion or appreciation of value; on the other hand, from the point of view of the new investors who bought the stocks at a premium above book value, they experienced stock dilution since upon entry, their buy price of PHP 2.00 a share is just now reduced to a book value of 1.20 a share. The otherwise would be true had the new shares been issued below book value. In that scenario, the existing owners would experience stock dilution whereas the new investors would benefit from stock accretion. We can therefore surmise that stock dilution/accretion occurs when new shares are issued or bought back below or above book value—at least if we’re talking about stock dilution/accretion, and not earnings dilution/accretion. Also, we can therefore guard ourselves from the immediate stereotype that “more shares issuance is bad”, since if those are above book value, stock accretion or value creation occurs for the benefit of the existing stockholders.

The Phenomenon of Earnings Dilution/Accretion

Another form of dilution/accretion occurs in earnings because of change in outstanding shares regardless whether shares were issued/bought back below/above book value.

Year 0

  • Equity = 100
  • Outstanding Shares = 100
  • Book Value = 1

Scenario 1: No new shares were issued or bought back
Year 1

  • Net Income = 15
  • Equity = 115
  • Outstanding Shares = 100
  • Book Value = 1.15 (115/100)
  • EPS = 0.15

Scenario 2: New 20 shares were issued at book value
Year 1

  • Net Income = 15
  • Additional Capital = 20
  • Equity = 135 (100 beginning equity + 15 net income + 20 additional capital)
  • Outstanding Shares = 120 (100 + 20 new shares)
  • Book Value = 1.125 (135/120)
  • EPS = 0.125

Earnings dilution therefore occurs because more shares would mean more and thinner slices of the earnings pie resulting to a lower book value (1.125 versus 1.15). Hence we might ask: is issuance or buying back of new shares good or bad? It depends on the overall resulting change to book value. If the action’s effective result is a higher book value, then the stockholder is better off.

Dividends and Share Buybacks as Impediments to Shareholder's Value Growth

This is precisely because of the Cost of Premium. Let’s start with buybacks. When a company buys back some of its shares at a premium, book value per share decreases.

Year 0

  • Equity = PHP 100
  • Outstanding Shares = 100
  • Book Value = PHP 1.00/share (PHP 100/100 shares)

Assuming 5 shares were bought back at PHP 2.00 a share.

Year 1

  • Equity = PHP 90 [PHP 100 – (PHP 2.00 x 5 shares)]
  • Outstanding Shares = 95 (100 – 5 shares)
  • Book Value = PHP 0.95/share

Hence, from PHP 1.00 a share in Year 0, book value in Year 1 is PHP 0.95. Also, assuming ROE is maintained at 15%, EPS prospect would now only just be PHP 0.14 (PHP 0.95 x 15%) rather than PHP 15.00 (PHP 1.00 x 15%) if no share buybacks were executed.

As with dividends, the case would be similar assuming one reinvests them—one has to pay up a premium. If not reinvested, they’d be static with no earnings potential or vested compounding power. The investor would have been better off if the company retained and compounded them at the rate of ROE. Yet the only case when buybacks and dividends would be beneficial is when market price is below book value. Here, the Gain on Discount applies.


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