Price to Book Method of Estimating A Stock’s Fair Market Value
March 27, 2012 By Bill Bullington
This technique is just one more way to quickly evaluate a stock to determine how over- or underpriced it may be. In my first book, I used an earnings-based approach in which we took a look at the sales and profit margins to estimate earnings. It’s a good approach and I use it most of the time. However, no single approach will make you fully aware of all the stocks that could be bargains. So think of this as just another weapon in your arsenal to help you to become a better investor.
Like the first method, it’s pretty quick once you get the hang of it, and it’s extremely effective. Like the first book, this material isn’t written for financial professionals—it’s written specifically for non-financial people. My goal is to take some very complex material and translate it into simple ideas that you can use to become a better investor. I’m sure some CPAs and PhDs in finance will be upset with my translation of their arcane accounting methods, but that’s their problem. There is no way to calculate the exact fair market value of a company using mathematical equations, no matter how sophisticated the model. If there were, we’d all be working for the first PhDs who came up with those models.
In reality, there are just too many factors that can and will change, preventing us from calculating an exact estimate of a stock’s fair market value. Still, that doesn’t mean you shouldn’t try. The real goal is to enable ourselves to quickly determine whether a stock is overpriced, and therefore extremely risky, or if it may be undervalued – and thus a potentially profitable investment.
Once you’ve filled out a large number of the worksheets (find them here: Excel Worksheet and PDF), you will very likely have developed the ability to perform the calculations in a minute or two. How cool is that?
Incidentally, knowing how to perform the analysis in this report will help you evaluate mutual funds or exchange traded funds. By comparing stocks in funds you are interested in with your estimates of fair market value, you may be able to evaluate how aggressive the portfolio managers are being with their investors’ money. Let’s say you like a particular fund. You do the analysis on the top ten holdings. Lo and behold, each and every one of those stocks is selling for more than twice the estimated fair market value (this was the case with lots of high-flying funds in the late 90s). Now you know to look for a different fund! If on the other hand you find that the stocks are reasonably close to your estimates of fair market value and the fund has an acceptable track record, you may have found a great fit for your investment portfolio.
By the way, you can pull up most mutual funds’ holdings on their company’s website. Thank the investment gods that Al Gore created the Internet. Just so you know, if everyone had been doing this in the late 90s, the Internet bubble wouldn’t have popped—because it wouldn’t have blown up to begin with. Investors would have seen how grossly overpriced the stocks in the most popular funds were and would have started selling sooner. But greed is a strange phenomenon.
At any rate, to utilize this approach, you only have to know a couple of definitions and a simple formula you’ll use to calculate the estimated fair market value of any stock. Here are the definitions:
LOFTB’s Book Value (per share) – The theoretical value investors would receive if a company was liquidated. You’ll need to look up a company’s financial statements to perform this calculation. I like to use the website money.msn.com for this information (MSN pulls the information from financial statements filed with the Securities and Exchange Commission – it’s hard to get better data than that!).
To calculate LOFTB’s Book Value per share, simply divide the entry labeled Total Equity on the company’s balance sheet by the Diluted Weighted Average Shares, which is found on the income statement.
In fact, let’s use Microsoft as an example. For the most recent quarter ending 12/31/2011, Microsoft’s balance sheet showed a Total Equity of 64 billion dollars. If we divide the 64 billion dollars in equity by the Diluted Weighted Average Shares of 8.465 billion, we arrive at an LOFTB Book Value of $7.56 per share (64/8.465).
Accordingly, if Microsoft were to be liquidated, each shareholder would get an equal share of the equity in the company and would receive about $7.65 per share. This is where the CPAs and finance professors start to get upset with me. They know that if Microsoft, or any other company for that matter, were to get into such deep financial difficulty that it had to be liquidated, shareholders may or may not receive full Book Value as payment. In some cases, they may actually get more than book value because of some hidden assets that wouldn’t necessarily show up on normalized balance sheets. And you know what? They’re right!
On many occasions, companies that have been liquidated have provided values that were significantly different than the values that were reported on their financial statements. Still, the accounting boards require that companies provide a reasonably conservative estimate of what the assets are actually worth for reporting purposes, so we are going to stick with this strategy for now. Our goal is not to be perfectly exact — it’s to be relatively close. Remember, anyone who thinks they’re perfect has obviously never been in a serious long-term relationship. You are presumably going to have a serious relationship with your portfolio.
So, if Microsoft were liquidated, would you be happy to get its Book Value as payment? Probably not, since its current share price is a little over $30. In reality, Microsoft is probably not going to sell for its Book Value unless it encounters big financial problems. Your guess is as good as mine as far as when that might happen.
Anyway, since we probably won’t be buying Microsoft for the price of its Book Value—unless it gets into big trouble financially—we need to estimate just how much we should be paying. To do that, we need to learn our next definition- LOFTB’s Return on Equity.
LOFTB’s Return on Equity – For our purposes, I’m going to define Return on Equity as the amount of profit the company makes in a given year, expressed as a percentage of Book Value. Again, I’m simplifying to make a point, so just keep your panties on straight, all you CPAs and financial people reading this! I’ll address the technical difficulties of this approach a little later in the report.
For now, let’s go back to our example of Microsoft. Microsoft reported $2.76 per share in profits over the last four quarters. If I divide $2.76 of profit into $7.56 of Book Value, I get a Return on Equity of 37%. In other words, $2.76 of profit is being produced by $7.56 of Book Value, and that works out to be slightly more than 37%. I have a tendency to repeat things when I want you to pay extra attention to them, if you haven’t noticed. It means I think it’s important! (Then again, it could be a result of all the concussions I had playing football in college, but that’s another story).
If you’ve ever wondered why people invest in companies, now you know. In theory, every dollar invested in Microsoft is currently earning more than 37% per year, which is a lot more than the return on a ten-year treasury or a Certificate of Deposit at the bank.
Additionally, the high Return on Equity is why Microsoft probably won’t sell for its Book Value any time soon. In fact, the relationship between the Book Value and fair market value can be calculated by using the following example. Pay attention because this is what you were looking for:
How to Estimate the Fair Market Value of a Stock!
I’m going to use the average rate of return on a ten-year Treasury note in my formula for estimating the fair market value of a stock, which is somewhere between 5-6%. I like to use 5%* and I’ll explain why later, but for now, let’s move forward with the example.
*ten year treasuries are currently paying 2%. I like to use the longer term average of 5% because it’s a more conservative approach.
Microsoft’s Return on Equity is 37%, and 37% is 7.4 times greater than 5%. Consequently, Microsoft earns 7.4 times more money than a 10-year Treasury note would normally pay in interest for every dollar of Book Value it has.
To put it another way: If you thought that Microsoft could maintain its 37% Return on Equity, you might be willing to pay 7.4 times Book Value for shares in the company.
If I multiply Microsoft’s Book Value of $7.56 by 7.4, I come up with a fair market estimate of $55.94. In other words, if I bought all of the shares of Microsoft for $55.94 and got to keep the profits of $2.76 per share, I’d be earning the equivalent of the ten-year Treasury note’s long term average of 5%.
If I paid any more than $55.94, I would be earning less than 5%. I probably don’t want to do that. Why? Because if I purchased a company and got to keep the profits, I’d want to make sure I could earn at least as much as someone who invested in treasuries.
On the other hand, if I bought every share of Microsoft and paid less than $55.94 per share, I’d be earning more than the long-term rate of return on ten-year treasuries. In fact, Microsoft currently sells for roughly $30 per share. If I owned all of the shares at that price and got to keep the earnings per share to myself, I’d have earned a rate of return over 9% in the last twelve months ($2.76 is 9.2% of $30)!
Since Microsoft is currently selling for $30 per share, it may be undervalued, incidentally.
You may be asking yourself why Microsoft is selling for so much less than its estimated fair market value. You’re probably even a little suspicious that this formula doesn’t work at all—and that’s normal. After all, why would something so obviously mispriced stay that way, if everyone knew about it?
The answer is relatively simple. The reason Microsoft isn’t selling for a higher price has a lot to do with the confidence of the investment community. When you know that Microsoft should be selling for $55 per share and it’s selling for $30, then it’s obvious that investors are nervous about its future prospects. Maintaining a 37% Return on Equity is not easy to do, and the investment community’s confidence level in Microsoft’s ability to do so in the future is clearly being questioned. The perception may change, however, and this is where the opportunity may occur. If Microsoft does maintain its high rates of return and the confidence of the investment community is restored, it may go all the way to $55 or higher. I can remember a time when Microsoft sold for more than 16 times its Book Value!
So that’s the challenge: do you think Microsoft will continue to grow and be as profitable as it has in the past? If so, Microsoft may be significantly undervalued. On the other hand, if Microsoft gets in trouble—say, it gets busted for spying on people using its operating system and an honest politician (one can always dream) finds out about it—it might be in trouble. As I like to say, in the realm of all possibilities, all things are possible. (I’m sure Microsoft isn’t tracking all of your activity, by the way – at least I hope not).
So let’s summarize what we’ve covered.
I’m kidding again. I know it’s not simple for beginners. Don’t fret; it took me a while to understand this concept as well. It’s the reason I’m including videos and the worksheets. Practice makes perfect!
Like the first method, it’s pretty quick once you get the hang of it, and it’s extremely effective. Like the first book, this material isn’t written for financial professionals—it’s written specifically for non-financial people. My goal is to take some very complex material and translate it into simple ideas that you can use to become a better investor. I’m sure some CPAs and PhDs in finance will be upset with my translation of their arcane accounting methods, but that’s their problem. There is no way to calculate the exact fair market value of a company using mathematical equations, no matter how sophisticated the model. If there were, we’d all be working for the first PhDs who came up with those models.
In reality, there are just too many factors that can and will change, preventing us from calculating an exact estimate of a stock’s fair market value. Still, that doesn’t mean you shouldn’t try. The real goal is to enable ourselves to quickly determine whether a stock is overpriced, and therefore extremely risky, or if it may be undervalued – and thus a potentially profitable investment.
Once you’ve filled out a large number of the worksheets (find them here: Excel Worksheet and PDF), you will very likely have developed the ability to perform the calculations in a minute or two. How cool is that?
Incidentally, knowing how to perform the analysis in this report will help you evaluate mutual funds or exchange traded funds. By comparing stocks in funds you are interested in with your estimates of fair market value, you may be able to evaluate how aggressive the portfolio managers are being with their investors’ money. Let’s say you like a particular fund. You do the analysis on the top ten holdings. Lo and behold, each and every one of those stocks is selling for more than twice the estimated fair market value (this was the case with lots of high-flying funds in the late 90s). Now you know to look for a different fund! If on the other hand you find that the stocks are reasonably close to your estimates of fair market value and the fund has an acceptable track record, you may have found a great fit for your investment portfolio.
By the way, you can pull up most mutual funds’ holdings on their company’s website. Thank the investment gods that Al Gore created the Internet. Just so you know, if everyone had been doing this in the late 90s, the Internet bubble wouldn’t have popped—because it wouldn’t have blown up to begin with. Investors would have seen how grossly overpriced the stocks in the most popular funds were and would have started selling sooner. But greed is a strange phenomenon.
At any rate, to utilize this approach, you only have to know a couple of definitions and a simple formula you’ll use to calculate the estimated fair market value of any stock. Here are the definitions:
LOFTB’s Book Value (per share) – The theoretical value investors would receive if a company was liquidated. You’ll need to look up a company’s financial statements to perform this calculation. I like to use the website money.msn.com for this information (MSN pulls the information from financial statements filed with the Securities and Exchange Commission – it’s hard to get better data than that!).
To calculate LOFTB’s Book Value per share, simply divide the entry labeled Total Equity on the company’s balance sheet by the Diluted Weighted Average Shares, which is found on the income statement.
In fact, let’s use Microsoft as an example. For the most recent quarter ending 12/31/2011, Microsoft’s balance sheet showed a Total Equity of 64 billion dollars. If we divide the 64 billion dollars in equity by the Diluted Weighted Average Shares of 8.465 billion, we arrive at an LOFTB Book Value of $7.56 per share (64/8.465).
Accordingly, if Microsoft were to be liquidated, each shareholder would get an equal share of the equity in the company and would receive about $7.65 per share. This is where the CPAs and finance professors start to get upset with me. They know that if Microsoft, or any other company for that matter, were to get into such deep financial difficulty that it had to be liquidated, shareholders may or may not receive full Book Value as payment. In some cases, they may actually get more than book value because of some hidden assets that wouldn’t necessarily show up on normalized balance sheets. And you know what? They’re right!
On many occasions, companies that have been liquidated have provided values that were significantly different than the values that were reported on their financial statements. Still, the accounting boards require that companies provide a reasonably conservative estimate of what the assets are actually worth for reporting purposes, so we are going to stick with this strategy for now. Our goal is not to be perfectly exact — it’s to be relatively close. Remember, anyone who thinks they’re perfect has obviously never been in a serious long-term relationship. You are presumably going to have a serious relationship with your portfolio.
So, if Microsoft were liquidated, would you be happy to get its Book Value as payment? Probably not, since its current share price is a little over $30. In reality, Microsoft is probably not going to sell for its Book Value unless it encounters big financial problems. Your guess is as good as mine as far as when that might happen.
Anyway, since we probably won’t be buying Microsoft for the price of its Book Value—unless it gets into big trouble financially—we need to estimate just how much we should be paying. To do that, we need to learn our next definition- LOFTB’s Return on Equity.
LOFTB’s Return on Equity – For our purposes, I’m going to define Return on Equity as the amount of profit the company makes in a given year, expressed as a percentage of Book Value. Again, I’m simplifying to make a point, so just keep your panties on straight, all you CPAs and financial people reading this! I’ll address the technical difficulties of this approach a little later in the report.
For now, let’s go back to our example of Microsoft. Microsoft reported $2.76 per share in profits over the last four quarters. If I divide $2.76 of profit into $7.56 of Book Value, I get a Return on Equity of 37%. In other words, $2.76 of profit is being produced by $7.56 of Book Value, and that works out to be slightly more than 37%. I have a tendency to repeat things when I want you to pay extra attention to them, if you haven’t noticed. It means I think it’s important! (Then again, it could be a result of all the concussions I had playing football in college, but that’s another story).
If you’ve ever wondered why people invest in companies, now you know. In theory, every dollar invested in Microsoft is currently earning more than 37% per year, which is a lot more than the return on a ten-year treasury or a Certificate of Deposit at the bank.
Additionally, the high Return on Equity is why Microsoft probably won’t sell for its Book Value any time soon. In fact, the relationship between the Book Value and fair market value can be calculated by using the following example. Pay attention because this is what you were looking for:
How to Estimate the Fair Market Value of a Stock!
I’m going to use the average rate of return on a ten-year Treasury note in my formula for estimating the fair market value of a stock, which is somewhere between 5-6%. I like to use 5%* and I’ll explain why later, but for now, let’s move forward with the example.
*ten year treasuries are currently paying 2%. I like to use the longer term average of 5% because it’s a more conservative approach.
Microsoft’s Return on Equity is 37%, and 37% is 7.4 times greater than 5%. Consequently, Microsoft earns 7.4 times more money than a 10-year Treasury note would normally pay in interest for every dollar of Book Value it has.
To put it another way: If you thought that Microsoft could maintain its 37% Return on Equity, you might be willing to pay 7.4 times Book Value for shares in the company.
If I multiply Microsoft’s Book Value of $7.56 by 7.4, I come up with a fair market estimate of $55.94. In other words, if I bought all of the shares of Microsoft for $55.94 and got to keep the profits of $2.76 per share, I’d be earning the equivalent of the ten-year Treasury note’s long term average of 5%.
If I paid any more than $55.94, I would be earning less than 5%. I probably don’t want to do that. Why? Because if I purchased a company and got to keep the profits, I’d want to make sure I could earn at least as much as someone who invested in treasuries.
On the other hand, if I bought every share of Microsoft and paid less than $55.94 per share, I’d be earning more than the long-term rate of return on ten-year treasuries. In fact, Microsoft currently sells for roughly $30 per share. If I owned all of the shares at that price and got to keep the earnings per share to myself, I’d have earned a rate of return over 9% in the last twelve months ($2.76 is 9.2% of $30)!
Since Microsoft is currently selling for $30 per share, it may be undervalued, incidentally.
You may be asking yourself why Microsoft is selling for so much less than its estimated fair market value. You’re probably even a little suspicious that this formula doesn’t work at all—and that’s normal. After all, why would something so obviously mispriced stay that way, if everyone knew about it?
The answer is relatively simple. The reason Microsoft isn’t selling for a higher price has a lot to do with the confidence of the investment community. When you know that Microsoft should be selling for $55 per share and it’s selling for $30, then it’s obvious that investors are nervous about its future prospects. Maintaining a 37% Return on Equity is not easy to do, and the investment community’s confidence level in Microsoft’s ability to do so in the future is clearly being questioned. The perception may change, however, and this is where the opportunity may occur. If Microsoft does maintain its high rates of return and the confidence of the investment community is restored, it may go all the way to $55 or higher. I can remember a time when Microsoft sold for more than 16 times its Book Value!
So that’s the challenge: do you think Microsoft will continue to grow and be as profitable as it has in the past? If so, Microsoft may be significantly undervalued. On the other hand, if Microsoft gets in trouble—say, it gets busted for spying on people using its operating system and an honest politician (one can always dream) finds out about it—it might be in trouble. As I like to say, in the realm of all possibilities, all things are possible. (I’m sure Microsoft isn’t tracking all of your activity, by the way – at least I hope not).
So let’s summarize what we’ve covered.
- To come up with an estimate of fair market value of a company using the LOFTB Price to Book Value approach, you first need to calculate LOTFB’s Book Value and LOFTB’s Return on Equity.
- Next, divide the LOFTB Return on Equity by 5 to find LOFTB’s Fair Price to Book Ratio.
- Finally, multiply LOFTB’s Book Value by LOFTB’s Fair Price to Book Ratio to arrive at the estimated fair market value of the company’s stock.
I’m kidding again. I know it’s not simple for beginners. Don’t fret; it took me a while to understand this concept as well. It’s the reason I’m including videos and the worksheets. Practice makes perfect!
No, I'm not a billionaire, but I have developed staright forward, explainable systems to invest wisely. Read more about m
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