Tuesday, May 22, 2012

What are Stocks Worth?

Many folks don't really understand stocks.   But if you use common-sense, it is not hard to figure out.

Buying Stocks is a mystery to most people.   One problem a lot of folks have in valuating stocks is that they believe they are all the same.   But this is not so - various types of stocks function in radically different ways.

The other day, I got to wondering, who in their right mind would buy Facebook stock?   And I searched online and found a website (which I strongly think is a put-up job) where this guy says he takes $500 from his 401(k) to buy Facebook stock.   "You never know!" he chirps, "After all, Google went up 100 times its opening price!"

Of course, others are quick to point out that Google increased only about six times its opening price, and that was only after a number of years of sustained profits and a huge business that dwarfs Facebook.   Facebook claims 900 million "active users"  - but many of these are just people, like my Dad, who opened an account, posted a message, and then never went back.

But this got me to thinking about the overall value of stocks.   What is it we are buying when we buy stock?  Is the whole game just rigged?   Would we be better off stuffing our money in a mattress?

Well, it depends.   The guy who bought the Facebook stock  without understanding what P/E ratio meant literally would be better off stuffing the money in his mattress.  Facebook stock tanked 11% yesterday, and Morgan Stanley is set to take another huge loss, as they propped up the issue by buying more shares.

But even assuming Facebook had a P/E ration of 11.2 instead of 112, would it still be a good buy?   It is smart to buy stocks that never pay dividends?

And the answer is, well, Yes and No.   You see, it depends on the types of stock - the type of company - and how it is possible to "cash out" of a stock.   Let's take a look at a few stock types and see what I mean.

1. Dividend Paying Stocks are not seen as "sexy" by the market, as their price remains pretty flat.   In troubled times, people flock to these stocks, as they are seen as safe investments - paying you back for the money you invest.

Utility stocks were seen as prime examples of these, at least until Enron.   But even today, a small, regulated utility company is a pretty safe and boring bet.   They go to the rate commission, tell them what their expenses are, the rate commission tacks on a "reasonable profit" and then sets the utility rates.  The utility company then churns out electricity and dividends for investors.   Since these are considered pretty "safe" bets, the price of the stock is adjusted by the market so that the rate of return is about the same as you'd get in a government-backed CD or bond.

Back in the day, for example, I might get a 5% dividend yield on my Dominion Resources stock.   Not a bad rate of return - today.  But back then, when the market was easily doing 10% a year, not a great investment.  But not too risky, either.   You spend $100 on that stock, and in 20 years, you make back your investment, just in dividends.   If the stock is worth $100 at that point, well, you've doubled your money.  If you reinvest the dividends (which many companies allow you to do) you may double your money in as little as 8 years.

Not sexy, not flashy, but solid.   And since the prices are pretty stable, there is not a lot for the shouting guy to shout about, except when the market tanks, and everyone shouts "buy!" which in turns drives the price up, and the effective yield down.  Today, Dominion Resources stock pays out about 4% in dividends (nearly all its earnings) but is diversified in a number of businesses - including foreign utilities.  Still a nice stock, but a little riskier than before.

And some utilities really got hammered in the Nuclear Power era, saddled with huge debts from expensive reactors.  I am not suggesting or promoting utility stocks, merely using them as an example.

Of course, there are plenty of other dividend-paying stocks out there.   And some of them pay high dividends, but that doesn't make them good investments.  Some companies actually pay out more in dividends than they make in earnings which is sort of like a snake eating its tail.   Desperate Directors may authorize huge dividends to prop up the stock price - in the short run.

Other companies may be paying out dividends, but for how long, is anyone's guess.   Frontier Communications has a whopping 11.87% effective yield (today) based on its sub-$4 share price.   It is earning more per share than it is paying in dividends.   But it is also losing customers, and some folks are skeptical that it will be around long enough to pay out more in dividends than you invest in dollars.   If you invest $100 in the stock, and it pays you back $24 in dividends in the first two years, but then tanks in the third, well, did you really make money?

So, that is one conundrum - even within one category of stocks there are different types.   Dividend-paying stocks are not all the same beast, it seems.

If you want to use an analogy, dividend stocks are akin to income-producing real estate.   You rent out a duplex, collect rents, and make money.  Maybe the duplex increases in value over time, but the rents churn out a 5% return every year.

2.  Buyout Stocks - a term of my own invention - represent stocks in companies that, well, someone might want to buy.  You could argue that all stocks are buyout stocks, but you would be wrong.   Some companies are just too large to be bought out, and their share price is too high to make them attractive.  Apple's valuation is nearly 1/3 cash, which ordinarily would make it an attractive buyout candidate.  But, since the share price is so high, well, no one would have the dough to buy it.

Smaller companies, however, are routinely bought and sold.  And when they are, this is a chance for  you to "cash out" and make money  on a stock, even if it pays no dividends whatsoever.

Stocks represent ownership and control of a company, and if someone wants to own or control a company, well, they have to pay you for that privilege, if you are a shareholder.   So, for example, when I bought Winn-Dixie at $7 a share, it seemed like a pretty good bargain.   And when Bi-Lo made a tender offer of $9.50 a share a few months later, well, I made a little money - an annualized rate of return of over 50%.   You can make money on a stock that doesn't pay you dividends!

But usually, these types of stocks are ones that are undervalued - and  you have to be able to see where a company is undervalued and be able to buy.   Warren Buffet is the king of this technique, seeing value where others see only fear and losses.   Recently he has been buying small-town newspapers, which people are ridiculing.   But maybe he sees some value there - at the prices he is paying.   After all, someone has to report the local news and be the "paper of record" for legal notices, right?   Maybe he is onto something.

But it is an inexact science.   You may think a company is undervalued, and buy the stock, and find out it is bankrupt, the next day.   Unless you really understand the company and its operations, it is a bit like gambling.   But perhaps not just lottery-gambling, but more like horse-racing, where you can at least inspect the horse before the race.

Most folks, however, buy these stocks when they are flying high.  And by the time the buyout comes, well, they are in the red and lose money on the deal.   A lot of Winn-Dixie shareholders were pissed off, because they paid $10 to $30 a share for the stock, and felt that $9.50 was a bad deal.   Worse yet, unlike me, who held the stock for mere months, they held it for years.  Talk about bleeding to death, slowly!

Going back to our Real Estate Analogy, these stocks are more like Real Estate that you buy-and-flip.   Riskier, to be sure.  But if you can see a piece of property that is undervalued, well, you might be able to make some money buying it, and then "cash out" when you sell it to a developer (as I did, buying for $185,000 and selling for $680,000.  Nice work if you can get it).   No income, but a lot of risk.  But a good payout if you judge risk properly.

3.  Speculative Stocks are stocks that pay no dividends, have no real earnings (at least proportional to their price) and are not likely to be "bought out" anytime soon.   The theory behind these stocks is that, while they are not worth much now, someday, down the road, they will take off like a rocket, and you, having gotten in on the "ground floor" will make millions.

These are the riskiest stocks you can buy, as they never pay anything back, and it is not likely that anyone would "buy them out" as they are so heavily over-valued.   The only way you can make money on them is to hope that some other chump will think it is worth even more than you do.

And Facebook and all the other "dot com" stocks fall into this field.   Sometimes these pay off - as in the case of Google, although even then, Google has a pretty high P/E ratio of 18, pays no dividends, and shows no signs of being bought out, anytime soon.   If you buy Facebook stock - or Google Stock - the only way you will make money on it - the only way - is to hope that some other chump will pay you more for the stock than you did.

The problem with these stocks is that we run out of chumps on occasion.   Companies seem to be on a winning streak, like Apple or Google, but then falter right at the finish line.   If there are no dividends, there are no assets to sell off, and no one wants to buy the place, then what is the real value of the company?

If the company really falters and slips, the stock price can be sent tumbling.  Panicked "chump" investors then sell off in droves, until some Warren Buffet gets out his calculator and thinks, "Gee, this company is actually under-valued now!" and makes a buyout offer.   But at that point, you only make money if you were brave enough to buy the stock when it was in the toilet.

So, you see why I own no Google, Facebook, or Apple stocks.   Even if they are successful, there is little way for you to "make money" on the stock, other than to hope that some other chump will pay more for an overpriced commodity.  Apple shareholders, perhaps sensing this, demanded that the company pay dividends, which it is now doing - at a rate of about $2.65 per quarter, or 1.9% at the current stock price.   This represents a huge dividend rate of return, (about 10%) of course, if you bought the stock at $100 a share in 2009.  But it also means you waited three years to get paid anything.

And if Apple's history is any indication, it may stop paying dividends if market conditions change.    The share price today is still, in my opinion, in the "speculative" column.   If you are buying Apple for the dividends, there are better places to invest.

Speculative stocks, are, in a way, like the buy-out kind, only the odds of a buyout are slim - you are paying extra for the property, not getting it at a discount.  Applying our Real Estate analogy, these stocks would be akin to buying a corner lot in town, hoping that, someday, a major gas station is going to want to locate there.   You are betting that a property, which has little worth right now, will someday be spectacularly valuable.   It is a very, very risky bet.

* * * 

Compounding this problem is the nature of our Stock Market.   It may come as a big surprise to you, but the stock market is the last outpost of legalized crime in our society.  You can start a company that has no chance of success, and then sell shares, make a ton of money, and then go bankrupt, riding in your limousine all the way to bankruptcy court.   So long as you put all the damaging information in the prospectus, you did nothing illegal.

So, for example, I could start a company and put in the prospectus, "The goal of our company is to sell a lot of stock, pay the founders huge salaries with that money, maybe try to do something to make some dough, but in the end, just cash out and live happily ever after on your dough.  Ha-ha!"  - and that would be legal.   And if an investor didn't read and understand the prospectus?  Well, too bad for him.  And in fact, that is sort of how the Facebook prospectus reads, if you think about it.  The only people who make money on IPOs are the founders, period.

Compounding this problem is that "legitimate" companies that have long track records of paying dividends and making good products, can go bankrupt, as GM did.   Worse yet, they can be co-opted, perfectly legally, by insiders, to turn them from "legitimate" to crooked companies overnight.  And as a small investor, you have no way of knowing.   Perhaps Enron started out to be a legitimate company.  But somewhere along the way, they went over to the dark side - even as the CEO was telling "the little people" to put all their money into it.

Worse yet are the market manipulators, who can use the media, rumors, stories, slogans, investment "plans" or just plain advertisements on television, to get you to buy something for more than it is worth.  Glenn Beck, before he was yanked off the air, spend three years running down the United States and instilling fear into his viewers.  Then he would cut to a commercial and say something like, "Friends, in these uncertain times, have you thought about investing in GOLD?" - not mentioning, of course, that he gets a "taste" of these investments.   To some extent, you CAN create demand for a product, if you keep hammering home the message - at least in certain people who lack critical thinking skills (about 90% of the populace).

And that is the problem right there.   Most people don't understand stocks, the tax code, basic finances - even fractions, for chrissakes.   Worse yet, they respond to information in the media like Pavlovian Puppies, salivating for Facebook stock, if only because they hear about it through repetition.

They go on websites and sign up for "schemes" of investment - as if a "formula" could tell you the secrets of the market.  "Put 1/4 each, into stocks, bonds, gold, and cash!" they shout, as if a chaotic system like the market could be reduced to a linear equation with four variables.

And usually, these "systems" and people shouting on TeeVee (or teenagers hyping penny stocks through SPAM e-mails) are just trying to manipulate the market, getting you to buy what they are in fact selling.

However, while these sort of manipulations may be immoral, they are often not illegal, even as people clamor for more regulations in these areas (as we had in the post-1929 era).   Thus, it is beholden upon YOU, the investor to not bite onto bad deals.   And the easiest way to do this is to not invest in things you don't understand.   Because chances are, if you can't figure out why an investment makes no sense, it isn't because you are "dumb", but because it is not a very good investment!