Thousand Dollar Thursday, A Grand New Deal Every Week

Saturday, August 27, 2011

STOCK MARKET VALUATIONS

STOCK MARKET VALUATIONS---AND THE WARREN BUFFETT MOVE INTO BANK OF AMERICA
   I hope in this blog to share some vitally important information on how companies value their assets, and how you might be able to find bargain stocks and build your wealth.
   Years ago, as a new real estate investor, I had acquired about a dozen properties. I got some really good deals, and I spent quite a bit of money fixing them up. I needed to do a financial statement and took all of my paperwork to a big accounting firm, at least for Tacoma, it was big. The CPA took all of my forms, paperwork and verifications and went to work. A week later I went in and looked at this beautifully bound Financial Statement. I was shocked. My net worth was nowhere near what I thought it would be.
   That day, I learned a valuable lesson in accounting. Let me introduce you to GAAP -- or Generally Accepted Accounting Principles. There is not enough time here to mouth off about all of it, suffice it to say, the valuations they wanted to use were not what I thought.
   For example. One property, which I had purchased for $60,000 was listed at about $60,000, even after some depreciation expense and some capital investments. It was worth $120,000, easily. "Not according to GAAP," he stated. "You have to list your assets at cost (meaning the adjusted cost basis) or the market value, whichever is less." I thought I misheard him. "You meant to say more, not less, right?" "No, it's whichever is less." "But that means on some properties I would have a negative basis, as I owe more in mortgages than this lower valuation." I started to get the picture. The only thing he would do is let me footnote the numbers, and explain in subsequent pages the real street values.
   Let me give two examples from today. First, a publicly traded company buys a $10,000,000 property. It depreciates it down to $9,500,000 over the years. They've taken good care of it, and the real street value is $12,000,000. They just refinanced the mortgage for $10,000,000. Now do the financial statement. Assets? Liabilities? The asset is listed at $9,500,000. Remember, cost or market whichever is less. Liabilities, $10,000,000, the mortgage. Yep, you added right. This property shows up as a net ($500,000) in equity, whereas in real life there's a $2,500,000 net equity.
   Example two: Your company has a chance to buy some private stock in a technical company to help it go public. The stock sold for $1, and you bought 10,000,000 shares. You list it on your books at $10,000,000. In six months they need more money and go out for a new round of financing at $2 per share. You're excited. Your stock value just doubled. Your balance sheet is going to look great. You're thinking your investment has turned into $20,000,000. It may have, but you must list it at $1, or the original $10,000,000, as your cost basis is lower than the new $2 per share. Then, a year later, they still haven't gone public and they need a little more money, but no one wants to get involved. They lower the price to 50 cents, and now guess what? That's right, your value is cut in half. Your 10,000,000 shares times 50 cents, the new market value, equals $5,000,000. Hopefully it will go public soon and you can list the stock at a public market value.

QUESTION OF IMPORTANCE
   Do you see that a company can have assets on its books that are worth far more in the real world than how they're characterized on their financials? And we can't go out and kick the tires all the time. The point is that many companies have huge values that are worth so much more than depicted.
   Okay, let's get back to banks and how their financial statements are different. Everything is backwards with banks. Let's just deal with real estate loans, as this type of loan, and Bank of America's purchase of Countrywide Financial is a big problem.
   Where we would list the property as an asset, banks list the outstanding (and performing) loan as the asset. They list the house as a liability. The property is their negative. If they take back too many properties (called REOs, or Real Estate Owned), they may not be able to make new loans, until they clean up their books. That's why banks will do almost anything to get rid of  REOs. In fact, this is the reason why banks are forestalling the foreclosure process on hundreds of thousands of delinquent mortgages.
   And it gets worse. Our benevolent government has now imposed new accounting rules, under the dubious title. "STRESS TEST." Here's how it goes with one mortgage. Imagine how bad their books would look with 10,000 of these foreclosed properties or non-performing loans. A bank loans $300,000 of a $350,000 home. Everything looks good. Real estate prices were stable but now their squishy. The test is this: How much would that loan be worth if you had to sell it now for cash? What? They don't have to do that. It's a stupid scenario, but it's government. Take it from someone who has seen government in action, up close and personal. It makes no sense.
   That's like asking this: You buy a car and two days later, you have to sell it now. I mean now. Your $25,000 is worth how much, especially if the buyers smell blood in the water? What can you get, 70%, 60%, or even less.
   The government test comes in around 30 cents on the dollar. I've heard of some at even 10 cents on the dollar. Who could stand such scrutiny? By the way, everyday you hear of banks closing their doors, or trying to become a different institution other than a bank. ABC $300,000 mortgage, (performing or not) is now valued at $90,000 on a good day. That's their asset. Their liability is the real estate. Are you starting to get the picture?

DOUBLE DOWN
   Now, let's even look deeper into this government mess. A bank could be perfectly healthy. Billions in reserve---enough to meet any normal contingency. But their balance sheet shows them running in the red. It could look bleak. Pardon me while I put in a little political commentary. I honestly believe this administration did this to take over certain banks (Like AIG, GM, etc) and to possibly nationalize the whole banking system. They started by nationalizing the student loan program, which took an important and vital money-making service away from banks. They have taken over others, and shut down others. It is quite sickening.
   Okay, back to the numbers, and then we'll get back to the Bank of America deal with Warren Buffet. Remember the loans? Tens of thousands of loans, underwater houses. Loans foreclosed on. Loans not performing quite right. The books look bad. Think it through. The bank created this $300,000 loan. The government poison makes them stress test it down to market, at say $90,000. The loan is in default so it's written down further, and the liability---the house (which in the real world could be close to $300,000 or more if the government would get their hands off of things)---which to everyone else is a positive asset shows up as a liability, skewing the whole picture. Now take this times hundreds of thousands. Aren't you glad we have a kind government that is willing to step in and save the day?
It's all bogus. Now, take some shrewd investors and/or attorneys and sic them on this situation. They know the real value. They position themselves to take advantage of the system. Bankruptcy judges are oblivious to GAAP, and the unsettling valuations the attorneys rip off.

WHAT'S THE TRUE VALUE?
   Let's speak to Book Value, or Break-Up Value. As the assets are listed on their financials, filed every quarter, so is the company valued and evaluated. Here's a rule-of-thumb number. Say a company has a book value of $8, which is what Microsoft used to be. Their stock will typically trade at 3 times this amount. If the book value is $50 (the current evaluation of all their assets---at the lesser value) the stock might trade at close to $150.
   What if you could find a company with a negative book value compared to their stock price. Say you have a company with a Book Value of $14 or $15, and the stock is going for $7? If this were a piece of real estate, valued at $250,000 and you could buy it for $125,000, wouldn't you jump at the chance?
So, just what did Warren Buffett see in Bank of America? Barron's listed the stock at trading at 57% of book value. And, (I know I've crossed the line of redundancy and circumlocution), this book value is way under the real value, but it is according to GAAP. What would you do? He saw the opportunity and he took it.
   He made the loan, getting preferred stock. He's getting 6% per year while he waits to convert the stock into shares locked in at $7.14. He's got unlimited upside potential with virtually no downside risk. So how do we tag along? Jump in the game, because the game is afoot.

BANK OF AMERICA AND P/E RATIOS.
   This won't take long. It's important to look at the P/E (Stock Price divided by the Earnings Per Share [EPS]---either past tense, future estimates of the P/E or a blend of both). Simply put, the P/E tells you how many dollars it takes to buy $1 worth of earnings. If the share price is $30 and the EPS is $1, the P/E is 30. If the EPS were $2, the P/E would be 15---stated as 15 times earnings. This is a simple, cabdriver's explanation.
   You want to find companies with a low P/E. The historical P/E, across the board, and through history, is 15.5. Today it is common to talk of stocks on the NYSE at 20 times earnings. NASDAQ at 30 to 40 times earnings. You can use this in a way to judge the stock you are thinking of buying. Say your target stock is trading at 18 Xs earnings. In that sector (banks, food, airlines, computer chips, etc.) the average P/E is 12. You would be paying a premium for your stock. If the average P/E is 25, then you would be getting your stock at a discount. This ratio applies to all prices of stocks. You could have a stock at 50 cents, $50, or $500. The ratio works out. You can also look at the earnings and see if they're growing from quarter to quarter, or year to year. I will write more on this in future blogs.
   Let's look at BofA. Barron's reported that the current P/E ratio was 4.9 times the estimated future year's earnings. That is really low. Yes, it could change, but often when the company makes a projection, or gives "guidance," the new word dujour, such guidance is on the low side. Companies love to give low numbers, reduce expectations, and then work like crazy to beat their numbers.

CONCLUSION
   4.9 times earnings. It's a bargain. The book value is upside down, in a positive way, even though we call it Negative Book Value. Like the jargon of the day---"BAD" means "GOOD." They have plenty of cash, and I still do not think they had to do this deal with Warren Buffet. It was to look good, and maybe get the FEDS to back off a little, with Warren and Barack being buddies like they are.
   Add all of this information to information in the previous blog and again I think you will see the game is afoot.
NOTE: Right now the option premiums say the stock is going nowhere. That will change very shortly. I like this as a covered call candidate, using the buy-back as I explained in my covered call book, STOCK MARKET MONEY MACHINE. Check out the book at Amazon.com---Create Space. It's available as an eBook or as a softbound book.
I have two more blogs on this topic. One is on government stress-tests, and the other is on the pricing of options. Stay tuned.
Abundantly Yours,
Wade

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