What makes a company valuable and what makes a stock a "Buy"?

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In this article, you will learn:

Lesson 3: What makes a company valuable and what makes a stock a buy?

What makes a company valuable?

We learned about the different types of stocks that investors look for in Lesson 2: Strategies for Stock Investing, but now we need to start looking at trying to value specific companies. There are a number of factors investors look for when looking for stocks to invest in:

  • The Product

knThis is the factor that people are most familiar with -- what does the company actually sell? This could be a simple range of products, like computers and computer accessories for Dell Inc. (DELL), or a huge range of different products, such as for General Electric (GE), which sells everything from aircraft jet engines to financial products. The product could be a service rather than a good, such as the banking services provided by Bank of America (BAC).

Once you know what a company sells, it is important to understand what kind of people buy that product and what sort of things affect the revenue generated from that product. For example, if Dell Inc. sells most of its computers to businesses rather than consumers, you need to consider what kind of spending decisions companies are going to make. If McDonalds (MCD) provides a nation wide chain of fast food products, you need consider the future eating habits of people in the population. These kinds of intuitive judgements are hard to make, but crucial in determining the long term value in a company.

You need to also consider what makes that product profitable for the business. One thing investors often look for is the scalability of a product - for example, Microsoft (MSFT) develops one version of the Windows operating system once every several years, and then sells millions of copies of the same product for the minimal cost of packaging and pressing a CD. These sorts of product features are the difference between a good company and the next multibillion-dollar company.

  • Competitive Advantage

While great products generate good profits, there will always inevitably be competitors who pop up and create similar or better products. The true difference between an average company and a hugely successful company is having a competitive advantage, which refers to anything that prevents competitors from simply copying your product and undercutting your prices.

This competitive advantage may simply be economies-of-scale, where companies can produce goods for much lower cost than their competitors due to their size. An example is a company like Intel Corp. (INTC). It takes a production level of thousands of computer chips a day before this business can be profitable. Any small competitor cannot match Intel on price, and so any new competitor would have to invest billions of dollars to scale very quickly and must gain market traction very quickly to be profitable, which leaves Intel as the industry leader. 

Another competitive advantage is the power of branding. Nike Inc. (NKE) can consistently charge much higher prices than its competitors because people recognize the Nike brand name and are therefore willing to pay premiums on apparel that they would otherwise not be willing to pay. This leaves Nike as one of the most profitable apparel companies in the industry.

  • Company Assets
While competitive products are what determine the long run success of companies, there are other valuable assets that companies may own or control that investors also look for. These include tangible assets, such as cash, land, buildings and equipment, as well as intangible assets, such as brand names and technology patents. Investors also consider the negative value of  liabilities, or the debts owed by a company to others. Value investors in particular look closely at assets and liabilities when looking at companies.

Net Assets per share = (Tangible Assets - Liabilities)  No. of Shares Outstanding

For example, one of the greatest investors of all-time, Warren Buffett, began his career as an investor by buying companies which had greater net assets per share, or book value per share, than their stock price. In fact, Buffett's $186-billion market cap investment holding company, Berkshire Hathaway, initially had its start as a struggling textiles business that Buffett bought a controlling stake in because it had greater net assets per share than the stock price was pricing in.

Products Competitive Advantage Assets
What's the difference between a great company and a great stock?

Remember from Lesson 1: What is the Stock Market? that earnings are ultimately what adds value to companies. Investors look closely at the past profitability of a company, or earnings. Specifically, investors look most closely at earnings per share, or EPS. This number represents the profits of the company divided by the number of shares outstanding. 

Earnings Per Share (EPS) = Earnings  Number of Shares Outstanding

This number is extremely important, because at the end of the day, earnings are what make companies valuable. Investors focus on EPS rather than just earnings because, if at any point, a company decides to issue more stocks, each shareholder owns a slightly smaller portion of the company, in what is known as stock dilution. If the number of outstanding shares grows faster than overall earnings, then EPS falls, and an investor's share of the company's earnings is shrinking. EPS measures the amount of earnings that each stock in a company is generating rather than just what the whole company is earning. Because of this, investors look for a steadily rising EPS in companies.

We spoke briefly in Lesson 2: Strategies for Stock Investing about the Price-to-Earnings Ratio, or PE of a company. The PE ratio is the current stock price divided by the earnings per share, and represents the multiple of earnings you are paying for the stock. For example, if you have a stock trading at $20 with an EPS of $1, then the PE for the stock is 20. Once we have the EPS number for a company, it is easy to calculate the PE ratio.

Price to Earnings Ratio (PE) = Current Stock Price  Earnings Per Share (EPS)

This number is extremely important. We spoke earlier about great products, competitive advantages and company assets as things to look for in a company. However, there is a big difference between a great company and a great stock. Warren Buffett famously said, "It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price". The price you pay for a company is just as important, if not more so, than the quality of the company itself.

For example, at the time of writing, Google Inc. (GOOG) trades at a PE multiple of 20.16, while Walmart (WMT) trades at a PE multiple of 11.73. Few people would argue that a mature, brick-and-mortar company like Walmart could possibly grow at the same rate as a relatively young and growing technology company like Google. However, an investor buying Google stock pays almost twice as much per dollar of profits for Google than an investor buying stock in Walmart. Therefore, the market has priced in growth for Google, because the market is willing to pay a higher price for a stock with greater potential for growth. We will discuss PE ratios and the exact valuations of stocks in Lesson 4: Using Discounted Cash Flow (DCF) Analysis to Value Companies and Stocks, but for now it is most important to realize that the price paid for a company is just as important as the quality of the company itself. Understanding this idea is a huge part of moving from being a novice investor to being a sophisticated, informed investor.

Price to Earnings Ratio PE Ratio

As a rule of thumb, a PE above 11 for a company indicates the market expects the company to grow its earnings over time, while a PE of 11 indicates a company will have zero growth in profits and a PE below 11 indicates the market expects lower profits than the company's most recent profit numbers.
What are some other key indicators investors look at to value a company?

Debt to Equity Ratio and Equity CushionAnother key financial indicator investors focus on is the debt held by a company. Obviously, if a company has a large, growing debt and no way to address it, they will sooner or later be paying a large portion of their profits out as interest on the loans, and face a growing possibility of bankruptcy. To get a quick idea of the debt levels of a company, investors often look at the Debt-to-Equity Ratio. Equity is the remaining value of a company after debt is removed, equal to company assets minus company debts.

Equity = Assets - Debt

Debt-to-Equity Ratio = Debt  Equity

The debt-to-equity ratio is important because it quickly tells the investor if the company has enough equity (or assets in excess of liabilities) to cover its debt. Usually any number below 0.5 is fine, a number between 0.5 to 1 needs to be considered more carefully and any number above 1 needs to be considered very seriously. It is important to note that some capital-intensive industries such as car manufacturing and industrials often have debt-to-equity ratios of around 2, but this is not considered unreasonable due to the nature of the business. Most importantly, these indicators should always be compared to competitors in the industry and other benchmarks rather than taken by themselves.

How do you find the information you need about companies?

Now that you know what to look for when valuing companies, you also need to know where you can find this information about the companies you're interested in. The original source of all this information comes from the annual and quarterly reports that publicly listed companies must release by law. In the United States, these report filings are required by Securities and Exchange Commission (SEC). The SEC has an electronic database with every filing from every listed company in the United States available online at the SEC EDGAR Database. The most important documents in this database are the annual financial reports of companies, also known as the 10-K annual reports. In this database, you can look up any listed company in the United States and find their 10-K, which includes an income statement with all a company's revenues and expenses, a balance sheet with all its assets and liabilities and a cash flow statement with all its cash flows.

However, the SEC database is complicated, and company financial reports are even more convoluted. It is better to use an existing stock research website that aggregates key financials of a company to begin screening companies. For example, to see the PE or debt-to-equity ratio of Microsoft, you can simply enter its stock symbol MSFT on the Stock Research page to get a summary of key financial statistics as well as financial charts over different time periods. In this way, you can easily look at up-to-date financial ratios and indicators of any listed stock.

Over time, it is a good idea to learn to read SEC filings as they contain important financial notes and other information not usually available in financial summaries of companies.