This article appeared in the January 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Roger Montgomery, Montgomery Investment Management
This article is the third of a series of special reports.
Attend a dinner party and throw this question out above the chicken Kiev and prawn cocktails - sorry, I mean the beef daube and chocolate fondant:
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 per cent 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 NetBanx.com and was trading at less than 50 cents. 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, licences, franchises, concessions, royalty agreements or labor contracts and no employees. It had 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 of 2000, the share price would have brought tears of joy. In March 2000, the shares traded at over $8 and 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 NetBanx.com - 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 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 per cent, or 50 per cent or 30 per cent, or decline by some other number? Are a company's shares cheap when the price-earnings ratio is below 10, or the dividend yield rises to 12 per cent?
As you will see, it is important that we value businesses independently of their prices. Only when the price for a company's shares falls significantly below this estimate of what the business is really worth do they 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 two times, and it may still be extremely expensive.
As you will discover, it is not the price-earnings ratio or any other common or popular ratio that tells you whether shares are cheap.
There is a way to compare apples with apples and 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, into which $10 million has been deposited. This bank account earns an after-tax return of 20 per cent per annum, fixed for 30 years. The interest cannot be reinvested. Given current interest rates on bank accounts of 5 per cent (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 I offer the account "for sale" and decide I am going 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. Warren Buffett said it took him a while to let go of his Graham ways and work this out, but his purchase of See's Candy at three times book value demonstrated he did indeed let go.
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 per cent 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 per cent.
To calculate this dumb price, we simply divide the after-tax return being paid by the bank account (20 per cent) by the return the investor would be content with - the dumb return (5 per cent) adjusted for tax - say about 3.5 per cent after tax. We then multiply this amount by the equity - the balance of the bank account. In the above example, this would look something like:
20 per cent ÷ 3.5 per cent x $10 million = $57.1 million
If someone paid $57.1 million for this bank account it would be very high and very dumb, because the return received would be a low, non-cumulative 3.5 per cent after tax.
You can check it: a $10 million account earning 20 per cent earns $2 million. Earning $2 million on the $57.1 million paid for the account is equivalent to a 3.5 per cent return.
As an aside, because the "20 per cent" in the formula represents the return on equity, which in turn equals profit divided by equity, the two "equity" items in the formula cancel out and you are left with:
$2 million ÷ 3.5 per cent = $57.1 million
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 per cent annual return after tax (let's leave inflation out of the discussion).
Applying the formula produces:
20 per cent ÷ 20 per cent x $10 million = $10 million
Therefore, paying anything lower than $10 million would be an even greater bargain.
It occurs to me 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 sharemarket, with its enormous liquidity and everyone 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.
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 being earned as the rate of return on equity. Now you've got it.
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.
Most recently, we purchased shares in McMillan Shakespeare at $7.25 the day they were relisted after former Prime Minister Kevin Rudd announced changes to fringe benefits tax that never transpired.
The sharemarket's participants will always overreact; ensuring the opportunity to buy great quality cheap will always be available.
About the author
Roger Montgomery writes as Chief Investment Officer at The Montgomery Fund. ASX Investor Update readers can obtain a free download of the full three-part Investing Guidebook
Revisit Roger's latest ASX Investment video "Lessons I have learnt".
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