Gauging a stock’s true value isn’t easy
Q: How can beginning investors know when a stock is overvalued or undervalued?
No one can know for sure. Seasoned and savvy investors might perform discounted cash-flow analyses with spreadsheets and might crunch other numbers, too, but their results will still be based on assumptions and estimates. Even great investors will disagree on the fair value of a stock.
Beginners can get a rough idea of how attractive a stock’s price is by comparing its current price-to-earnings (P/E) ratio with its P/E range over the past five to 10 years. Coca-Cola, for example, was recently trading with a P/E around 30. A glance at its P/E’s past (available at morningstar.com, among other sites) shows that its average P/E over the past five years is roughly 23. That suggests that Coke’s stock might be overvalued.
Of course, there’s much more to the picture. Potential investors should assess a company’s strengths, weaknesses and competitive advantages, among other things, along with its cash, debt, profit margins and growth rates.
Fool’s school: Private equity
Many of us have heard the term “private equity” a lot without understanding what it is. Here’s a quick overview.
In a nutshell, privateequity firms typically engage in the following activities: raising money from private investors such as wealthy individuals and institutions; researching and buying companies; guiding and/or making cost-cutting improvements at those companies; selling those companies for a profit.
At their best, privateequity firms might be rescuing a company that’s on shaky financial ground and offering valuable guidance to help right the ship.
There’s a darker side to private-equity firms, though. For one thing, many don’t have a long-term view regarding the companies they buy: They want to boost the companies’ value and sell at a profit. Many times, thousands of workers will be laid off in the interest of cost-cutting.
There are several kinds of private-equity organizations. Venture capital (VC) enterprises tend to make somewhat-risky investments in young, growing companies before the companies have IPOs (initial public offerings) and issue stock to the public. Companies such as Apple and Microsoft once tapped venture capital.
Leveraged buyout (LBO) outfits will buy big public companies with a lot of borrowed money. The LBO company will often take the company private and use much of the company’s excess cash to pay the LBO company’s debt, often while trying to improve the efficiency of the company. Eventually, the acquired company will be sold to another buyer or to the public, via an IPO.
Private-equity firms aren’t required to release quarterly performance reports or audited financial statements, as public companies must do. They enjoy some tax advantages as well. Money invested in private equity is often tied up for at least several years.
Some of the biggest private-equity firms are The Blackstone Group, Kohlberg Kravis Roberts, Warburg Pincus, The Carlyle Group and Apollo Global Management. The biggest LBO deals have included KKR’s purchase of RJR Nabisco in 1989 and Blackstone’s purchase of Hilton in 2007. Foolish trivia:
Name that company
I was founded before the Civil War, in Providence, Rhode Island, in 1846. I’m known for my pens now, but my first products were wooden pencils, elegantly encased in silver and gold. I created my first fountain pen in 1889 and my first ballpoint pen in 1953. I now sell a Bluetooth-enabled pen that can help its owner find it via an app. Many presidents have signed legislation with my pens. My offerings, which have included journals, timepieces, nonprescription reading glasses and business accessories, are sold in 89 countries. They’ve long been popular corporate gifts. Who am I?
Last week’s trivia answer
I was born in the Great Depression, when my founder moved to Arkansas and began delivering chickens. My business got a boost in World War II, as chicken wasn’t among the foods being rationed, causing demand for it to grow. Today, I’m a top global food company, producing about 1 in every 5 pounds of chicken, beef and pork in the U.S. Who am I? (Answer: Tyson Foods)