To be a successful investor, you have to know what your stock positions are worth. I’m not referring to simple metrics like the current stock price or market capitalization. I’m talking about the actual value of a firm using concepts and fundamentals found in corporate finance.
If this investment strategy sounds familiar to you, it’s probably because one of the most famous investors in the world lives by this type of inventing – Warren Buffet. The Oracle of Omaha only places his capital in companies that he can actually analyze and measure. This is the old school way of investing and it’s still popular for a reason – it works. After all, the purpose of corporate finance is to maximize firm value to benefit the shareholder.
Corporate finance is a broad term, but it can be broken down into different components consisting of capital budgeting, risk management, cost of capital, capital structure and a dividend policy. For the purpose of stock valuation, I’m going to focus on a company’s dividend policy, the cost of capital and how that capital is used.
Dividend Policy
In order to run a business, capital is needed to pay for expenses and make investments. The money that remains is referred to as free cash flows. If the business has no other NPV (net present value) positive opportunities, then it may decide to pay some of the money back to investors in the form of dividends.
Keeping this in mind, it’s easy to see why dividends can be a glimpse into the profitability and growth of a company. A successful organization will continue to raise dividends, resulting in a positive growth rate. The theory is that the free cash flows are also increasing simultaneously.
Look at this scenario in terms of your personal finances. If you are consistently bringing in more and more money each month and you expect that growth to continue, your future looks pretty good.
Cost of Capital
Cost of capital is what a company pays to borrow funds in order to pay for business expenses, purchase equipment, complete projects, etc. As an investor, you want to look at what it costs for a company to borrow funds and whether or not the cost is greater or lower than the return on the money.
On the balance sheet, you can find out what a company pays on its loans and bonds in the form of interest payments. Much like people, riskier companies will have to pay a higher interest rate than established firms with extensive credit history.
How Capital Is Used
Once you’ve discovered how much a firm pays for its capital, the next step is to analyze what they spend it on. For example, a company that pays 5% on its corporate bonds has cost of capital (debt) of 5%. To fund a $10,000,000 project, they would sell 10,000 bonds with a coupon payment of 5%. It is worth it to fund the project if a return greater than the 5% cost is expected.
From an investment perspective, a company that doesn’t manage its money wisely is not a solid investment. On the other hand, companies that do not invest much capital and sit on large amounts of cash cannot be expected to grow rapidly.
This same philosophy can be applied to your personal finances to get a better understanding. If you are able to secure a loan with a 5% interest rate (selling bonds) and in turn make 10%, that would be considered a solid investment.
READERS: How can you apply these philosophies to your own finances? Do you currently use any of these techniques to analyze a possible investment? If so, has it worked out well for you?
