What is currency? The official definition is a system of money in general use in a particular country. If that weren’t confusing enough, we now have to define what money is. Money is any circulating medium of exchange. To be more clear, money isn’t simply dollars, euros, coins or anything that you are used to calling “money”. It is much, much bigger than that.
Money is anything that could be exchanged for other goods and is widely accepted. Unlike the barter system, money allows us to have a somewhat uniform idea of what things cost and what they are worth. For instance, it would be difficult to figure out how many llamas can be exchanged for 2 cows, but with money we could exchange llamas for money and then money for cows. Money could be beads, coins, paper, or essentially anything that we know could be exchanged for something else in the future.
What does this have to do with stocks? I think these definitions have very strong implications for the way we should invest and value companies. Corporate officers and even employees sometimes receive stock in leu of bonus checks or wages. This is monetary compensation although cash hasn’t been exchanged. Companies sometimes give stock dividends instead of cash to shareholders. This is also monetary compensation, is widely accepted and can be exchanged later on. Even in instances where companies are seeking to merge or acquire other companies, they may do so by exchanging their stock for the shares of the other company. Clearly, stocks are being used as money.
What about currency? Well certain forms of currency are accepted in other countries, such as the U.S. dollar. Also, certain exchanges have certain stocks. The TSX, NASDAQ, Euronext, and HKEx, all list different companies. This lays the foundation for stocks as money and currency.
How can we use this foundation as a way to value businesses better? We do this by looking at a company’s market cap and per share price. The best way to do this is by comparing two companies, and seeing which would be a better exchange for our money. We ultimately want our money to grow, including our stocks, which would add value to us.
To me, it doesn’t really matter too much whether the stock is in a certain sector or not, except when trying to construct a portfolio that has businesses with low correlations to each other. Generally, it is best to compare businesses in the same sector or industry in order to get a better idea of how well a business is doing. For this exercise, I don’t think it matters too much whether the companies are in comparable industries, but I will use two companies in similar industries so that there isn’t any confusion.
Lets take a look at Microsoft and Adobe. The core business for each of these companies is software development and licensing its services. Both of these technology companies are household names, so which one would be a better buy? Let’s look at the market cap and price per share before we look at some ratios. This isn’t an in depth look at either company, and it is always best to look at a company’s financial statements before investing.
When we look at market caps, we see that Microsoft’s market cap is 344.46 billion while Adobe’s market cap is about 36 billion. Generally, market caps only determine whether a company is large or small, but for the purpose of this article we are going to do things a little different. Since we buy companies at a per share level and agree to their overall market cap valuation, we are going to say that for one Microsoft market cap, we can have 9.5 Adobe market caps, all else being equal. If this is the way money works, then logically, Adobe should be priced at or around 9.5 times less than Microsoft. This example of course is ignoring the economic theory of supply and demand, so it shouldn’t be too surprising that Microsoft is priced at $41.70 a share while Adobe is priced at $72.36 dollars a share. It is also important to keep in mind that market valuations don’t always follow logic.
Adobe is priced at almost twice the per share price of Microsoft. If you wanted an Adobe share, it could be exchanged for 1.73 shares of Microsoft. For your $72.36, you could either exchange it for 1 Adobe share or 1.73 shares of Microsoft. Which exchange adds more value to you as an investor? We need to briefly look at some ratios to make a slightly more informed decision. There are plenty of ratios to choose but we’ll stick with price ratios for the purpose of our example.
P/B- MSFT 3.99 ADBE 5.40
P/E- MSFT 15.8 ADBE 130.9
P/CF MSFT 13 ADBE 59.4
Dividend Yield: MSFT 2.65% ADBE Does not pay a dividend
What the ratios tell us is that for 1.73 shares of MSFT, we would have a company that is price about four times its book value, 15.8 times its earnings and 13 times its cash flow. We would also receive a dividend every quarter totaling 2.65% a year. On the other hand, if we bought 1 share of Adobe, we would have a company that is priced 5.4 times its book value, 131 times its earnings and 59.4 times its cash flow, without receiving any dividend from the company. It seems as though ADBE may be overpriced and it would be much better to exchange my money for MSFT.
I think it’s important to look at stocks as a type of currency, or money, when we are valuing different businesses. It helps us put in perspective the prices we pay for the businesses we invest in, and the alternatives we could have exchanged them for. If we want our money to grow, we need to ensure that we are making the right exchange for businesses that add value and raise our wealth. Let’s keep our cash cows and let others trade magic beans.