Stock Price Follows Book Value

Stock price follows book value and thus business fundamentals (although not in a linear time scale) by a combination of growing book value and economic value. The correlation will never be 1:1 in the short term, but over time superior investing can be achieved by understanding fundamental concepts. Some basic concepts we’ll need to understand the journey of stock price appreciation:

1. Book Value: Book value is the value of equity. The amount of assets of a business that belong to the equity shareholders. The calculation is total assets – total liabilities

2. Shares Outstanding: Shares outstanding signify the amount of pieces of the equity ownership. Shares outstanding are important because this determines the equity value that is allocated to each piece of stock. (example, same equity base and increasing shares outstanding results in declining stock price)

3. Return on Net Tangible Assets: The return a company receives on operational investments. For more in depth detail visit our page on the topic: Link

4. Return on Equity: The return a company receives on invested equity capital. For more in depth detail visit our page on the topic: Link

5. Price: The price paid for a company matters. This price is also called the valuation or multiple. For more in-depth detail visit our page on the topic: Link

TLDR

There are two pieces of stock value and thus two pieces that influence stock value growth over time.

1. The stock ownership percentage in the present value of all future cash flows of a business plus terminal value

2. The valuation (multiple/price) placed on those cash flows

In order for point number one to grow and thus grow the stock price, a business must generate more cash flow each year or buy back stock in order to shrink the market cap and thus increase the percentage of ownership of each outstanding share. Cash flow (or earnings) per share must increase. Terminal value is captured in the book value per share. A company’s intrinsic value per share (stock price) per year should grow equal to book value growth.

Stock price growth (or depreciation) will also happen with multiple expansion (contraction), or the markets willingness to pay more (less) for a company’s cash flows. For considerations on why this happens visit:

1. How to Value a Company

2. How a Company Increases Return on Assets

3. Investing through Market Cycles

Stock Price Follows Fundamentals by Growth in Book Value

Growth rate in book value will tie closely to the growth in intrinsic value of a company over the long term. Easy right? This intuitively makes sense because to grow cash a company needs additional cash producing assets. In a simple example, imagine a trucking company with one truck. That truck produces $100 of cash flow over and over, year after year. A company would increase in value every year by $100 since there is an additional $100 in cash on the balance sheet.

In order to grow book value, a company uses reinvested cash flow from operations, debt, or stock sales. When looking at growth in a company’s book value, make sure to verify the debt growth per share as well. Often times, company’s will leverage debt to buy cash generating assets if the return is greater than the cost of capital. For example if debt (bonds) cost 5% and production assets are returning 25%, a company will grow their assets with debt. An investor will notice that growth in liabilities per share will mirror growth in book value per share in these cases. To see a case study here, let’s look at 10 year performance of Graco Inc (GGG) vs Dominos Pizza. GGG has fantastic organic growth and Domino’s Pizza is leveraging debt to acquire high return assets:

Graco

GGG’s ROE and liabilities per share remain relatively flat during the past decade while book value continues to grow from organic cash flow.

Domino's Pizza

DPZ’s growth in liabilities per share directly tie to the growth in book value over the past decade. Domino’s is leveraging debt to grow at a 20% annual rate.

Company Book Value per Share Use Cases

Here are some examples of company’s increase in book value per share (vs gross book value above) and increase in stock price (per share) over the past 20 years calculated with Wisesheets:

Coca Cola

Domino's Pizza

Graco

IBM

Growth in Return on Equity

The investor will notice that some companies (like Apple, Inc) show a shrinking of book value per share. This is the case when a company is buying back shares (shrinking the market cap) and thus shrinking its equity base. When a company buys back shares, cash (total assets) and equity reduces by the amount of cash spent on buybacks. Net income and liabilities remain the same so the book value per share is disproportionally reduced. When this is the case, look at a company’s growth in return on equity. The growth in return on equity should track to growth in stock price. Below is a simple example of two balance sheets, one before the buybacks and one after:

The ROE increases to 67% from 50% and the stock price should follow suit as those company cash flows are now more valuable to the equity investor.

Economic Value above Book Value

The second main element of a stock price is the price paid for cash flows. Rarely are stocks priced at book value. This phenomenon exists because there are future cash flows the company will generate. If a company’s stock is priced at book value then the company is either deteriorating or undervalued by the market. To make matters more complicated, the price attached to cash flows differs between companies and between industries. The price however is closely tied to economic value. Economic value of a company is represented by the return on tangible assets a company generates. A company that generates 50% on tangible assets is naturally worth more than a company that generates 5% on tangible assets. If a company can’t generate more than 5% on assets, then an investor should just invest in bonds at 5% for much lower risk.

Summary

A company will either grow the asset base and generate more cash/income per share (growth in book value) or the company will shrink the equity base through share buy backs and increase the amount of cash owed to equity investors (growth in return on equity). These two elements are affected by the underlying business and thus the “real economy”. The last piece to consider is the valuation (price) placed on cash flows via the market. This valuation is much more volatile as it’s a financial metric versus an underlying business fundamental.

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