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Stock Price

Dear Dave
I’m a candidate for ownership in our firm. I’m being offered the chance to initially buy a 5% stake in the firm with the possibility to buy an additional 5% conditioned on several specific firm and personal performance goals being reached. The terms and conditions have been spelled out fairly clearly and I really don’t have any major concerns other than the cost of the stock. The price is based on a formula that combines the firm’s book value with a multiple of annual average profits. As a dollar amount, it seems like a lot of money. But how high is high? How do I know if the asking price for the stock is fair and reasonable?

Dear SH
By comparing the anticipated rate of return (ROI), and the potential risk, for any money you might invest in your firm to all other investments options that may be available to you, or to simply doing nothing at all with the money in the first place.

On a purely financial basis there are two basic reasons to buy any stock—the potential your stock will appreciate in price and/or your stock will generate additional income. The combination of appreciation and income equals the ROI.

To begin your ROI analysis ask your firm to demonstrate, using the stock price formula, how the stock price has changed over at least the three previous years along with a projection forward for the next several years. Does the projection seem reasonable and achievable based on the firm’s history and your opinion of the firm’s future prospects? If not, you may wish to discount the projections to a level you do have confidence in.

Next, ask the firm what changes to your income you may expect (if any) by virtue of buying stock. Does the firm pay an annual cash dividend to shareholders? Will your salary change? Will you participate at a different level in bonus pools?

Combine the expected annual dollar value of the projected stock price appreciation, with any income you can identify specifically associated with ownership to determine the total annual return of your investment. Finally, compare the annual ROI to the initial purchase price to determine the rate of return for your stock. Based on the expected annual ROI, how many years will it take you to recoup your initial investment? Does it seem reasonable given alternative investment opportunities and the potential risks associated with owning your company’s stock?

If the annual ROI is weighted more to expected stock appreciation, with little if any additional annual cash income anticipated, can you afford to hold this investment, or do you require increased income to replace the cash (or perhaps pay back a loan) used to make the stock purchase?

To be sure, there are numerous non-financial reasons to consider an ownership offer. Many view ownership as a statement of professional accomplishment and personal recognition. Others may place a high value on owning stock as a method to gain influence and control over their circumstances. Regardless of your non-financial motives, any investment, including one in the place where you work, should make sense financially as well.

Wahby and Associates