F is for Friends who do Research Together
When you read the title to this article, if a small jingle came into your brain, then I can tell you right now we would probably be friends. However, luckily for both of us, we do not have to go through the arduous process of getting to know each other. All I have to do is write the articles and all you have to do is read them, it’s so much simpler than speaking face to face. You know what else is great for avoiding face to face interaction? Investment analysis, and that’s probably why you want to learn it, huh? Well, let’s continue on our journey towards wealth and loneliness, follow me!
Last week I touched on the topics of P/E ratio, PEG ratio, and economic moat. These are first screeners that should be used when trying to identify an undervalued security, however, this is far from a complete list. In fact, there is not a complete list and there never will be a complete list. It is important to understand that investing is not a science, it is an artwork that can be approached in a scientific manner. There is not a right way or a wrong way to invest but there is a successful and an unsuccessful way that is simply based on historical observation. This does not always mean that these “proper” ways to invest will persist into the future, and that is why investing is an artwork, because as time passes the way to successfully invest changes with it. Or in other words, you have to be able to think for yourself. Any book, article or scholarly journal you ever read on investing will simply be a tool to add to your wealth of knowledge on how to invest. You will develop your own strategies and understand how to think your way through situations with these tools at your disposal. Thinking for yourself cannot be done without the development of the tools, though.
An important ratio in determining a company’s true worth is the price-to-book ratio (i.e. P/B). You are probably saying, “What book is this weirdo talking about, I don’t even like to read (anything but my articles), forget this!” Wait, don’t leave, it’s not a real book. The book value of an individual asset is the asset’s cost that it was bought at minus any accrued depreciation expense. The book value of a company is a company’s sellable assets minus its liabilities. Therefore, it is “different than equity value which is simply all of a company’s assets minus its liabilities whereas book value is a company’s assets minus its intangible assets (goodwill, patents) and liabilities” (Investopedia). This ratio is important because it tells us “the total value of the company’s assets that shareholders would theoretically receive if a company was liquidated” (Investopedia). This means that we can generate insight into how the stock is being valued when we compare book value per share to the price per share.
For example, if a stock is trading at $24 dollars per share and the book value per share is $25, then the company’s assets minus its intangible assets and liabilities is actually worth a dollar per share more than what the market is valuing it at. Which means that if another company were to acquire this firm it is almost guaranteed that the acquiring company would pay more than the $25 dollar per share book value to buy the tangible assets. This is a good indicator of intrinsic value because it has direct ties to tangible assets within a firm. Book value leads us to the price-to-book ratio which is simply the price per share divided by the book value per share. Do you think we want this ratio to be higher or lower? I want to believe that you are right, I mean I can’t hear you, so I will just give you the benefit of the doubt. It should be lower because we would never want to pay more (share price) for the same amount of real assets (book value). Same way if you had two identical toasters next to each other, you would (hopefully) go with the cheaper one. The intrinsic value of the ratio is defined by B (book), and the price we are paying is the P (price).
We are missing one step with this ratio still, we need to compare it to relative peers. If every company in the financial industry has a P/B of 1, then a P/B of 1 doesn’t necessary indicate great value in the financial sector. If every company in the healthcare sector has a P/B of 12 and you find a company with a P/B of 3, then it is possible you have found a depressed security and it might be worth looking into further (does not mean it is time to dump your life savings into it).
Just like all other ratios, it is far from perfect and must not be taken at face value. Outside of needing to compare it to its peers, you must also understand that the book value on the balance sheet is simply historical cost. This means that if an asset was bought for $25 million years ago then it would be valued as a $25 million asset minus depreciation. This can be a problem because assets change value as time passes. That depreciated asset might be worth something very different in the market place than what it is recorded at, even with depreciation being accounted for.
Now you might be saying, “Well, what is the point of even using this metric if we cannot trust the denominator of the ratio?” Good question. To answer it I need to paint a picture. Imagine investment analysis being similar to building model airplanes. Each and every ratio and combination of ratios is an abstraction from the entire investment picture. We use these ratios to help us interpret what is actually happening in real life. Ratios are to a company’s true financials what model airplanes are to real airplanes, simply abstractions from the real thing that gives us insight into how something is functioning. We can add different features to the model airplane to make it more and more realistic which help us paint a more accurate picture of the real thing. We can even add a motor and make it a remote controlled model aircraft that flies! The same way that we could make a working financial model that gives the company an intrinsic value. However, since we do not work at Boeing or Goldman Sachs, we could never actually build a whole airplane or accurate discounted cash flow model because that is a full-time job in itself. We simply want a toy plane that can accurately and efficiently reflect the real thing. Same with investment analysis. We want to make as many abstractions from the real situation in as efficient of a manner as possible that gives us the best snapshot of the reality that we are abstracting from.
To answer your question, it is not the denominator of the ratio that is supposed to tell you whether or not your money is best allocated in the security. It is your job to interpret the ratio in a manner which properly abstracts from the reality of the situation in order to give you the best inside look into whatever you are researching. This is the simple reason why there is such competition to obtain the best information as an investor. The quality of your information is your competitive advantage. The way you interpret that information is what makes you a quality investor. The main difference between investing and building model airplanes is that building a model airplane has physics to back up the results of doing it the right way or wrong way. Investment analysis is taking as much or as little information as you need in order to make the best decision you can, your abstraction is your science and your interpretation is your art.