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Learn about Bailout 3: Book value vs. market value

So let’s see where we left off. We were studying the balance sheet of this Bank A. I think that’s what I called it. We said okay on their asset side, we had some government bonds, we had some triple A corporate bonds and commercial mortgages and then this is the thing that I really wanted to highlight is that it also had four billion dollars of residential collateralize and obligations. Then I explained a little about what those are and I have several videos where I had explained that in more detail and how they probably led or most definitely led to the housing bubble. And then we have a little bit of cash on top of that.

On the liability side, the bank just owns a lot of money to people. If this were a commercial bank, a kind of you know your Bank of America’s or your chases of the world and then one of the liabilities here would have also been the deposits of the people who can’t keep their money at the bank but we are not going to assume that this could be just kind of any bank. Actually, this could be any type of financial institution frankly. It doesn’t have to be a bank. This could be the balance sheet of a hedge fund or a private equity firm or pretty much any type of financial institution.

Anyway, back to where we were in the ex ample. We said and we learned it in the first video and we learned it in the balance sheet video that if you take your assets, and you subtracted out your liabilities, so you take what you have, you subtract out what you owe. You’re left with what you really worth and that’s called your equity. Ad if you’re publicly treated company, actually you done even have to be publicly treaded. If you’re corporation, that’s called your shareholders equity. And what does that mean? Well, that means that the people who own a stake in the company or the shareholders. They share this piece. And just to may hit the point home, I think this is an important one because I feel like people kind of talked passed this.

There’s two notions. There is your book value of equity and that’s the value of the equity that comes out of your balance sheet. So if you assume that everything all of these numbers are accurate and we are going to think a lot about what it means to have an accurate number here and you assume that all of this numbers are accurate then the number that pops out on the equity side, that is the book value of your equity.

And just as an example, I said well let’s say that bank A is a public company. It has 500 million shares and so that means that if you take it’s 3 billion dollars of equity divided by 500 million shares, that means that there is $6.00 of book equity per share. So that means if all of these numbers are correct then the stock of that company is worth 6 dollars per share exactly, exactly $6.00 per share. And they’re saying “wait Sal, that1 doesn’t make sense”.

We all know that the stock market is a wild ride especially banking stock. They swing, left and right and up and down. How can you tell me that you know just by looking at the balance sheet, you can give an exact amount for what its equity value is? And that is an important distinction. So let me scroll down a little bit. Maybe, I’ll erase this.

Actually, let me clear this out because I think this is a distraction. We might just want to watch the video on mortgage back securities and collateralize that obligation if you’d to refresh it there. So what does it mean when you know? I am telling you right now that you can look at the company’s balance sheet and if you believe what they say, you can actually calculate a book value per share. So why do stocks fluctuate wildly left and right? Well it’s interesting, it actually tells you a lot about what the market thinks about the company’s balance sheet. So let me fill this in, this was 26 billion of assets and then I had what 23 billion of liabilities. And then we get, that’s how we got equity of 3 billion and book equity per share or the book value per share of $6.

Now, let’s say we you know we go on to yahoo finance and we typed in the thicker symbol for this bank, you know bank A, whatever you want to call it and let’s say that its market price is I don’t know. It is $12.00 per share. So what is happening here? The book value is $6.00 but the market is saying “no, no, no, we are willing to pay $12.00 per share for one of those shares” And just make a point here, when you look up a share price in the stock market or even better when you buy a stock on the stock market, that money is not going to the company.

The company initially raises money by selling shares and that’s often done with an initial public offering. They will sell some shares directly to the market and that money goes directly to the company or they might do it in an offering and we will talk more about that later. But 99% of the time, when you buy a share, it is not going to the company. It is going to the previous person who held that share and that’s why it is called a secondary market. It‘s not going to the company. So it is just a bunch of people trading the share price and the only reason why that share price really fundamentally matters to the company is if the company were to raise money at a future date.

Let’s say the share price today is $12.00. Let’s say I bought a share for $12.00 a share today. That means I bought it from, maybe I bought it from you. I didn’t buy from the company but that at least tells the company that if it were to go to—if it needed money, if it needed to raise money, it could sell shares probably at something close to $12.00 a share. It also tells someone who wanted to buy out the whole company so if they wanted to take over the company, then maybe if they offered some type of a premium to $12.00 per share, they could buy out all the stock.

That’s not the topic for this and actually the more I think about it, I really should do videos on all of these concepts. Anyway, so the market is giving you $12.00 per share value. What does that mean? The person who is paying $12.00 a share is assuming that this is understated. The book value is understated and so if the book value is understated, that means that either the assets are understated or the liabilities are overstated.

Most times, the liabilities are pretty easy to get a handle on. Sometimes pension liabilities or some type of litigation liabilities that’s hard to get a graph on but most of the time, you could look at a balance sheet and then just say okay this is the money they owe. That’s not too hard to value. What is often very interesting to value are the assets on a balance sheet.

So if you know, with this balance sheet, you would say $6.00 per share but the market is going to say 12 then you will say you know what, the company either of these assets are somehow being undervalued or the company might have some assets that somehow are not captured on the balance sheet. Something that you maybe they are intangible assets or there are some type of earning power that in some way is not captured you out.

I think when I originally did the videos on balance sheet, I actually talked about you know. You can’t quantify charisma and good looks and so that’s maybe why you know I have more assets than my balance sheet might predict. Well, this notion is the same thing but on the company level. Maybe, if this was, if this were Goldman sack’s balance sheet, maybe it’s a book value per share $6.00 but the market is going to pay $12.00 worth because it’s Goldman Sacks. That’s the corporate equivalent of charisma and good looks.

They say you know, just to buy their brand, they are able to make more money than everyone else. They are able to do more with whatever assets we give them. So I’m willing to pay a premium to their book value.

You know, whether or not that’s true, that’s a tough case. I think that argument can very easily be made with the company like Coca Cola where it does have a very powerful brand where that brand and that formula, that secret formula, really are the value of the firm and they probably aren’t captured on the balance sheet. With the bank, I’d be a little more skeptical of paying a significant multiple of this. Here, what multiple are we paying? If this is the market value, so let’s say this is the stock price or the market stock price. I’d be skeptical of paying two times the book value but it’s actually not hard to find a lot of companies that are trading at far more than two times the book value.

That’s what it means, that’s what the market is essentially saying. If they are paying $12.00 per share for something that essentially has a book value of $6.00 per share. They are saying all or maybe one of these assets are worth more. Maybe they had you know, on the books, there is like a property here in I don’t know Manhattan that they bought 50 years ago that they have it on the books for 50 cents but maybe the shareholders say “oh no that’s really worth a million dollars or something” I don’t know.

Another way to think about is this that the market is paying $12 million per share. What’s the market capital of the company? And the market capital of the company is really the—what’s the market’s guess of what the shareholders equity is? So the market cap, you take $12.00 per share multiply it by 500 million shares so 12 times 500 million or let’s say 0.5 billion and you get a six billion dollar market capital. So if the equity is trading or if the stock is trading that day at $12.00 per share, that says that the market or at least the people on the margin, trading that stock that day and I’ll do a whole other set of videos on what that means and how prices are set.

But that means that they think that this equity isn’t 3 billion that it’s actually worth $6 billion and I told you for all the reasons maybe the brand is with the lot or they have some secret formula. One of these assets somehow is understated. So that’s fine, that’s the situation where the market price is above the book value. But what’s the situation where, let’s say that on that day of trading, the share price is that $3.00 per share. Well, if you say three times 0.5 billion that means that the market says that this company’s market cap is 1.5 billion.

Or another way of viewing it is that this is the market’s guess or you could use out the market value of the equity. This is the market’s guess of the value of this company’s equity. So the market says “okay I don’t care that you know bank A says that they have $3 billion, that their assets minus liabilities are 3 billion. We don’t buy it.” We actually think that this is only $1.5 billion and it’s probably because they think that one of these things on the left hand side of the balance sheet, one of these assets are worth less than what the bank says their worth.

I mean it could be that you know one of these liabilities worth more. Maybe, there are some types of environmental liability that the company is somehow understating but let’s not get too complicated right now. I’ll do a bunch of videos on that. When the market value or the market cap is below the book value the book equity, that’s the market to say “hey we are calling your bluff something here doesn’t smell right, something here isn’t worth what you say its worth” And I would just realize that I’m out of time and I will continue this in the next video.

Posted: 03/11/2009 | Views: 1,234 | Duration: 10:32