Tuesday, 28 July 2009

Business Valuations versus Stock-Market Valuations

  1. The impact of market fluctuations upon the investor's true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses.
  2. The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice.
  3. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet.
  4. On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment - when the market is open, that is - and often is far removed from the balance sheet value.
  5. The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner.
  6. The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or "balance-sheet value").
  7. In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.
  8. This is a factor of prime importance in present-day investing and it has received less attention tha it deserves.
  9. The whole structure of stock-market quotations contains a built-in contradiction. The better a company's record and prospects, the less relationship the price of its shares will have to their book value.
  10. But the greater the premium above book value, the less certain the basis of determining its intrinsic value - i.e., the more this "value" will depend on the changing moods and measurements of the stock market.
  11. Thus, we reach the final paradox, that the more successful the companyl, the greater are likely to be the fluctuations in the price of its shares.
  12. This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be - at least as compared with the unspectacular middle-grade issues.
  13. (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)
  14. The argument made above should explain the often erratic price behaviour of our most successful and impressive enterprises.
  15. Our favourite example is the monarch of them all - International Business Machines. The price of its shares fell from 607 to 300 in seven months in 1962-63; after two splits its price fell from 387 to 219 in 1970.
  16. Similarly, Xerox - an even more impressive earnings gainer in recent decades - fell from 171 to 87 in 1962-63, and from 116 to 65 in 1970.
  17. These striking losses did not indicate any doubt about the future long-term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.
  18. The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks.
  19. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value - say, at not more than one-third above that figure.
  20. Purchases made at such levels, or lower, may with logic be regarded as related to the company's balance sheet, and as having a justification or support independent of the fluctuating market prices.
  21. The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it.
  22. A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, (1) a sastisfactory ratio of earnings to price, (2) a sufficiently strong financial position, and (3) the prospect that its earnings will at least be maintained over the years.
  23. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions.
  24. Once the investor is willing to forgo brilliant prospects - i.e., better than average expected growth - he will have no difficulty in finding a wide selection of issues meeting these criteria.
  25. More than half of the DJIA issues met our asset-value criterion at the end of 1970. The most widely held investment of all - American Tel. & Tel. - actually sells below its tangible-asset value as we write. Most of the light-and-power shares, in addition to their other advantages, are now (early 1972) available at prices reasonably close to their asset values.
  26. The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high mutlpliers of both earnings and tangible assets.
  27. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market.
  28. More than that, at times he can use these vagaries to play the master game of buying low and selling high.

Ref: Intelligent Investor by Benjamin Graham

Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company's physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company's annual and quarterly reports; from total shareholders' equity, subtract all "soft" assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.

Graham's use of the world "paradox" is probably an allusion to a classic article by David Durand, "Growth Stocks and the Petersburg Paradox," which compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an inestor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share? Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows and the higher the cost of even a tiny miscalculation becomes.

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