How To Quickly Tell If A Stock Is Cheaper Than It Looks

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 the enterprise 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 generic examples to illustrate the advantages of using EV.

P/E and P/S Ratios

Let's imagine there are two companies, Company A and Company B, each with the exact same sales, earnings, share count, and stock prices:

Company A and Company B:

Sales: $1 billion
Earnings: $100 million
Share Count: 100 million
Stock Price: $15.00/share

Given this, we can calculate the market cap, price-to-earnings (P/E), and price-to-sales (P/S) ratios easily. Each firm would have the same values:

Market cap: $15 * 100 million = $1.5 billion
Price-to-earnings (P/E): $1.5 billion / $100 million = 15
Price-to-sales (P/S): $1.5 billion / $1 billion = 1.5

So far, so good. In most financial screens, both Company A and Company B would look valued exactly the same.

When A Stock Is More Expensive Than It Looks

The balance sheet is where Company A and Company B diverge. Take a look at their respective cash + investments and debt burdens:

Company A:

Cash and investments: $10 million
Debt: $500 million

Company B:

Cash and investments: $500 million
Debt: $10 million

Now, let's calculate the enterprise value as described earlier for each firm:

Company A Enterprise Value: $1.5 billion - $10 million + $500 million = $1.99 billion

Company B Enterprise Value: $1.5 billion - $500 million + $10 million = $1.01 billion

Carrying this out to the P/E and P/S ratios, and replacing "P" (market cap) with "EV" (enterprise value):

Company A EV/E: 19.9
Company B EV/E: 10.1

Company A EV/S: 1.99
Company B EV/S: 1.01

Wow! It turns out that we would be paying almost twice as much for Company A than for Company B - with the same revenues and earnings! Market cap (and by proxy, the P/E and P/S ratios) cannot capture this.