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What's it worth?

In this Part 3 of our Value Investing Series for Cuffelinks, we complete the circle and provide some insights into the final step required to overlay a value investing philosophy successfully upon your share portfolio.

Attend a dinner party and throw this question out above the chicken kiev and prawn cocktails, sorry, I mean the beef daube and chocolate fondante: What’s any asset worth?

More than likely the answer proffered will be: What someone’s willing to give you for it!

This is 100% wrong. What someone else will give you for something is the price. What it is really worth – its value – is something else entirely.

If you don’t agree, consider the following example.

In mid-1999 in the United States there was a company previously known as Professional Recovery Systems Ltd that became and was trading at less than 50c. Around the same time, a Securities and Exchange Commission filing read:

The company is not currently engaged in any substantial business activity of any description and has no plans to engage in any such activity in the foreseeable future … [and] It has no day to day operations at the present time. Its officers and directors devote only insubstantial time and attention to the affairs of this issuer at the present time, for the reason that only such attention is presently required.”

The company had no principal products or services, no patents, trademarks, licenses, franchises, concessions, royalty agreements or labour contracts and no employees. It has assets of less than one thousand dollars. That’s right, its assets were just $989.

Had you purchased (gambled) shares in the company in July 1999 around the time of the addition of the ‘.com’ to the company’s name, you might soon have been smiling. At the peak of the internet bubble in March 2000, the share price would have brought tears of joy, as it traded at near enough to $9! The shares subsequently declined, along with everything else that ended in ‘.com’, and eventually the shares were delisted. True to label, the company never conducted any business activity of any description.

But here’s the point. If an asset is worth what someone else will give you for it, someone was willing to give you more than $8 for a share of this company. Was – a company that did nothing and wasn’t planning on doing anything – ever worth $8 or more? The answer is clearly no. The price was $8 but the intrinsic value was zero.

Price is what you pay for something, but value is what you will receive and the value will ultimately determine your return. Your job as an investor then, is to own shares that are worth more than you paid for them.

How do you know when a share is cheap?

Are a company’s shares cheap after they fall 70%, or 50% or 30%, or decline by some other number? Taking a look at the salivating going on among investors towards mining stocks, you’d think their recent falls must surely mean they are cheap.

Are a company’s shares cheap when the price-earnings (P/E) ratio is below 10, or the dividend yield rises to 12%? Isn’t a low price-earnings ratio or a high dividend yield a sign that the shares are cheap? When your measure of value is derived from the price, you are mixing raisins with turds and as Charlie Munger (Warren Buffett’s long-standing colleague) once observed, you can mix raisins with turds but they are still turds.

As you will see, it is important that we value the business independently of its price. Only when the price for a company’s shares falls significantly below this estimate of what the business is really worth, does it become truly cheap. It doesn’t matter what the price-earnings ratio, price-to-book ratio or dividend yield is. You can have a company on a price-earnings ratio of 25 times earnings or more and it may be a bargain. You can have a company’s shares trading on a price-earnings ratio as low as five times, and it may still be extremely expensive.

There is a way to compare apples with apples, to put all businesses on a level playing field in terms of estimating their true worth.

Suppose I have a hypothetical bank account in the name of Roger’s Valuations Pty Ltd, in which $10 million has been deposited. This bank account earns an after-tax return of 20% per annum, fixed for 30 years. The interest cannot be reinvested. Given current interest rates on bank accounts of 5% (and that’s pre-tax!), my $10 million account looks very desirable. I bet there would be a few people willing to buy it!

Now suppose that I offer the account ‘for sale’ and I decide to auction it off. What should you be prepared to pay for it? Without any arithmetic, you know intuitively that it is worth more than the $10 million sitting in the account. If the money in the account represents my ‘equity’ or ‘book value’, then the intrinsic value of this account is higher than that equity or book value. Buffett said it took him a while to let go of his Ben Graham ways and work this out, but his purchase of See’s Candy at three times book value demonstrated he did indeed let go.

Some people prepared to pay more than correct value

How much higher than the equity is the true value of the bank account? At an auction I would discover what people are prepared to pay. But people can get pretty silly in an auction environment. If I pitched the auction with some marketing teasers such as, ‘last account of its type in the world’, or ‘never to be repeated opportunity’, then I may generate some irrational exuberance and someone could pay a really dumb price. But that dumb price is not necessarily what the account is worth either.

What would a dumb price be? Interest rates offered by some bank term deposits might be 5% and they offer the benefit of reinvestment and thus compounding. I would argue that someone would be paying a ‘dumb’ price for the Roger’s Valuations Pty Ltd account if the interest coming off it amounted to less than 5%. That’s not to say it wouldn’t or couldn’t happen, it’s just that if it did, the buyer might be irrational and you’d be tempted to let them have it.

To calculate this dumb price, we simply divide the after-tax return being paid by the bank account (20%) by the return the investor would be content with – the dumb return (5%) adjusted for tax, say about 3.5% after tax. We then multiply this amount by the equity – the balance of the bank account. It would look something like:

20% ÷ 3.5% x $10 million = $57.1million

If someone paid $57.1 million for this bank account it would be very high and very dumb, because the return they would receive would be a low, non-cumulative 3.5% after tax.

You can check it: A $10 million account earning 20%, earns $2 million. Earning $2 million on the $57.1 million paid for the account, is equivalent to a 3.5%.

Using the same formula through which the dumb (high) price is derived, we can also arrive at the bargain (low) price. If you were to pay $10 million – the amount of equity actually in the bank account – this would be a bargain price because you would end up receiving a 20% annual return after tax (let’s leave inflation out of the discussion). Applying the formula produces:

20% ÷ 20% x $10 million = $10 million

Therefore, paying anything lower than $10 million would be an even greater bargain. It occurs to me that you might be thinking, ‘I could never buy this Roger’s Valuations Pty Ltd account at an auction for $10 million – forget about buying it for less!’

In a rational trade sale environment, you would be right. With the vendor and purchaser in a locked room with only their lawyers and accountants attending, it is less likely that a real bargain could be obtained. But thanks to the continuous auction environment that is the stock market, with its enormous liquidity and every one focused on what the price will do next, irrational reactions to events unrelated to the bank account’s earnings power frequently push prices to both dumb and bargain levels.

So what might be a reasonable price to pay? When rates of interest elsewhere are very low, it is probably unrealistic to adopt them as your own required return. With the going rate on a bank account that offers the opportunity to reinvest being 5%, it would be unrealistic to be satisfied with the same return from an account that doesn’t offer compounding. An investor should require a higher return. In any case, eventually interest rates go back up. There is also inflation to think about.

In such a situation you should require a rate that better reflects a return that will compensate you for inflation and for the possibility that interest rates might rise. And if there’s a risk that the bank paying the interest could default or fail, you would require some compensation for that too. Or, if that risk existed you may avoid bidding for the account altogether.

For now, let’s say we want a 10% after-tax ‘required return’. We can establish that if you are going to buy that $10 million bank account that earns 20%, you should be willing to pay no more than 20% ÷ 10% x $10 million = $20 million.

Again, at an auction, someone is willing to pay a lot more than you. As an investor, you should be willing to say good luck to them and pass.

Good investors must be patient

You are now in the business of finding bargains, and if a bargain cannot be obtained today, the market will open again tomorrow offering you a fresh new opportunity and a new price.

Your job – now that you know how to identify great businesses and once you understand how to value them – is simply to ignore periods when dumb prices are being paid and wait for ‘bank accounts’ to be available at bargain prices. If that doesn’t happen today or this week or this month, so be it. An opportunity will eventually present itself. It always has and it always will.

The bank account just described has the same characteristics as a company that generates a constant return on its equity and pays all of its earnings out as a dividend.

But what if the bank account allowed you to reinvest all of the interest each year and compound it? At the end of year one, there would be $12 million in the account, earning 20%; at the end of the second year, there would be $14.4 million in the account earning 20%, and so on. The value of such an account is clearly higher than the same account that does not allow the reinvestment of interest. A bank account that allows for the reinvestment of all the interest (earned and thus compounding) has the same characteristics as a company that generates a constant return on equity and retains all of its earnings.

The non-compounding account will only ever have $10 million in it and earn $2 million every year. It is still very attractive, but not as valuable as an account that earns $2 million the first year and then earns 20% more on the interest every year after that.

There is one little twist. In the above example, the account that retains its interest and therefore grows its earnings is considered to be worth more than the account that pays all of its interest out. This is because we have assumed that the 20% interest rate it earns is very attractive compared to everything else available. If, however, there were many other accounts available that earned more than 20%, it would be the account that paid all the interest out that would be worth more. Why? Because the account that retains all the interest and compounds it will ‘only’ earn 20%. If you can get a higher rate elsewhere, you are much better off owning the account that pays all the interest out, allowing you to reinvest it yourself elsewhere at a higher rate.

All this talk about bank accounts and interest income might seem misplaced when discussing investing in businesses listed on the stock market. It isn’t, however, if you think of the bank account as a business, the balance of the bank account as the equity invested by the owners in that business, and the rate of interest as the rate of return on equity. Now you’ve got it.

Roger Montgomery is the Chief Investment Officer at The Montgomery Fund and the author of the Australian bestseller investment guide


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