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. And we said, OK on the assets side, had some government bonds, had some AAA corporate bonds, some commercial mortgages. And then this is the thing that I really wanted to highlight, that it also had $4 billion of residential collateralized debt obligations. And I explained little bit about what those are. And I have several videos where I explain 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 owes a lot of money to people. If this were a commercial bank, kind of your Bank of Americas, or your Chases of the world, then one of the liabilities here would have also been the deposits of the people who keep their money at the bank. But we're 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. But anyway, back to where we were in the example. 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 subtract out your liability-- so you take what you have, you subtract out what you owe, you're left with what you're really worth. And that's called your equity. And if you're a publicly traded company, actually you don't have to be publicly traded, but if you're a corporation, that's called your shareholders' equity. And what does that mean? Well that means the people who own a stake in the company, or the shareholders, they share this piece. And just to hit the point home, and I think this is an important one because I feel like people kind of talk past this. There's two notions, there's 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're going to think a lot about what it means to have an accurate number here-- and you assume that all of these numbers are accurate. Then the number that pops out on the equity side, that is a 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 its $3 billion of equity, divide 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 $6.00 per share. Exactly $6.00 per share. And you're saying, wait Sal, that doesn't make sense, we all know that the stock market is a wild ride, especially banking stocks. They swing left and right and up and down. And how can you tell me that you know just by looking at a balance sheet, you can give an exact amount for what its equity value is? And that is an important distinction. Let me scroll down a little bit. Maybe I'll erase this. Actually, let me clear this out. I think it's a distraction. You might just want to watch the video on mortgage-backed securities and collateralized debt obligations if you need a refresher there. So what does it mean when, I'm telling you right now that you can look at it 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 a company's balance sheet. Let me fill this in. This was $26 billion of assets. And then I had $23 billion of liabilities. And that's how we got equity of $3 billion. And book equity per share, or the book value per share of $6.00. Now let's say we go on to Yahoo Finance and we type in the ticker symbol for this bank-- Bank A, whatever we 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 saying no, no, no, we are willing to pay $12.00 per share for one of those shares. And just to 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'll 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. That's why it's called a secondary market. It's not going to the company. So it's 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. So let's say the share price today is $12.00. Let's say I bought a share for $12.00 dollars a share today, that means maybe I bought it from you. I didn't buy from the company. But that at least tells the company that 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, that maybe if they offered some type of a premium to $12.00 a share, they could buy out all of the stock. But 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. But anyway, so the market is giving a $12.00 per share value, what does that mean? The person who's 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 grasp on. But most times, you can look at a balance sheet and you say, OK 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, with this balance sheet, you would say $6.00 per share, but the market is willing to say $12.00. Then you say, either these assets or somehow being undervalued or the company might have some assets that somehow are not captured on the balance sheet, right? Maybe they're intangible assets. Or there's some type of earning power that in some way is not captured here. I think when I originally did the videos on balance sheets, I actually talked about you can't quantify charisma and good looks. And so that's maybe why I have more assets than might balance sheet might predict. Well, this notion is the same thing, but on the company level. Maybe, if this were Goldman Sachs' balance sheet, maybe its book value per share is $6.00. But the market is willing to pay $12.00 for it because it's Goldman Sachs. That's the corporate equivalent of charisma and good looks. They say, just by their brand they're able to make more money than everyone else. They're able to do more with whatever assets we give them. So I'm willing to pay a premium to their book value. And whether or not that's true, that's a tough case. I think that argument can very easily be made with a 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 their balance sheet. With a bank, I'd be a little more skeptical of paying a significant multiple of this, right? 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. So that's what it means. That's what the market is essentially saying if they're paying $12.00 a share for something that essentially has a book value of $6.00 per share. Or maybe one of these assets are worth more. Maybe they had, on the books, there's a property here in Manhattan that they bought 50 years ago that they have it on the books for $0.50. 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 it is, if the market is paying $12 million per share, what's the market cap of the company? And the market cap of the company is really what's the market's guess of what the shareholders' equity is? So the market cap, you take $12 per share, multiply it by 500 million shares. So 12 times 500 million, or let's say 0.5 billion. And you get a $6 billion market cap. So if the equity is trading, or if the stock is trading, that day at $12.00 dollars per share, that says that the market, or at least the people on the margin trading that stock that day-- and I'll do not another whole 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. I told you for all the reasons, maybe the brand is worth a lot, or they have some secret formula, or 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 we say 3 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 call it the market value of the equity. This is the market's guess of the value of this company's equity. So the market says, OK I don't care that Bank A says that they have $3 billion, that their assets minus liabilities are $3 billion. We don't buy it. We actually think this is only worth $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 they're worth. It could be that one of these liabilities is worth more. Maybe there's some type 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. But when the market value, or the market cap, is below the book equity, that's the market just saying, hey we're calling your bluff. Something here doesn't smell right. Something here isn't worth what you say it's worth. And I just realized that I'm out of time. And I will continue this in the next video.