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Magic Diligence
Magic Diligence

How to Quickly Tell if a Stock is Really More - Or Less - Expensive than it Looks

February 21, 2014

Wouldn't it be great to know if a stock is really more - or even less - expensive than it looks from its stock price?

In actuality, this is pretty quick and easy to do, and more investors should do it. Here's how...

What a Stock Price Represents

A share of stock is a piece of ownership in a company. To get the total value of the company (how much it would cost you to buy the whole thing), you multiply the cost of one share by all of the outstanding shares. This is known as the market capitalization of the firm:

Market Capitalization = Cost per Share * Number of Shares

For most investors, this is as far as it goes. Market Capitalization is used as a key component of the well-known valuation metrics, serving as the "price" portion of the price-to-earnings (P/E) and similar ratios. Generally speaking, the lower values for these ratios, the cheaper a stock is.

But this is ignoring some important characteristics of a company. We can do better with just a little effort.

Replace Market Capitalization With Enterprise Value

Say you were a private equity firm, or a large company looking to acquire a smaller firm. You are buying the "whole enchilada" - gaining control of that smaller firm's assets BUT also assuming all of its liabilities.

Therefore, if that smaller firm had a lot of cash in the bank and carried no debt, that much cash is essentially handed right back to you, making the deal cheaper than it looks. On the other hand, if that smaller firm had more debt than cash, you assume that debt, making the deal that much more expensive.

By subtracting net cash (or adding net debt) to the market capitalization, we create a figure called theenterprise value, or EV. In its simplest form (which we will stick to for the purpose of this article), enterprise value is calculated like so:

Enterprise Value = Market Capitalization - Total Cash + Total Debt

This can then be divided by number of shares to compare to the stock price. Companies with a lot of net cash will have an enterprise value LOWER than their market cap, while debt-laden firms have an EV HIGHER than their market cap.

Once you have an EV figure, you can plug it in, in place of market cap, to get EV/E (instead of P/E), EV/S, and any other price-based ratio to get even more meaningful valuation metrics.

Let's do a few examples to illustrate the advantages of using EV.

More Expensive than it Looks - Prestige Brands

Let's start with a stock that is actually quite a bit more expensive than it looks - Prestige Brands (PBH). Prestige has an enormous amount of debt for its size - $1.03 billion - and a relatively small cash position of $94 million. Let's see how its market cap and enterprise value stack up:

PBH Market Cap = $27.90 per share * 51.8 million shares = $1.45 billion ($27.90/share)

PBH Enterprise Value = $1.45 billion - $94 million + $1.03 billion = $2.39 billion ($46.14/share)

Accounting for its debt makes Prestige about 65% more expensive than it looks! See how this affects its P/E and price-to-sales (P/S) ratios:

P/E 19.25, EV/E 31.82
P/S 2.34, EV/S 3.90

Using these modified EV ratios, PBH looks a lot less like a value stock than it did with the more traditional ones!

Less Expensive than it Looks - Cisco

It can work the other way, too. A stock that is actually CHEAPER than it looks is one everyone knows - Cisco (CSCO). Like many of the tech giants, Cisco carries a big cash cushion on its balance sheet, with cash and investments totaling about $47.1 billion, vs. $17.2 billion in debt. See how this affects the enterprise value vs. the market cap:

CSCO Market Cap = $22.30 per share * 5.29 billion shares = $118.1 billion ($22.30/share)

CSCO Enterprise Value = $118.1 billion - $47.1 billion + $17.2 billion = $88.2 billion ($16.67/share)

Due to its strong balance sheet, Cisco is actually 25% less expensive than it looks! Cisco is already a relatively "cheap" stock at a P/E ratio of 14.7, but looks even more attractive using EV:

P/E 14.7, EV/E 11.0
P/S 2.46, EV/S 1.84

Using these ratios, Cisco would show up even higher on value screens.

About the author:

Magic Diligence
GuruFocus - Stock Picks and Market Insight of Gurus

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