When is a share good value?

A multitude of books exist on the subject of value investing as well as newsletters and articles and yet according to Warren Buffett there appears to be no trend towards value investing.

Unlike those have previously written on this subject we believe that P/E ratios and dividend yields have nothing to do with value investing. Value investing means buying an asset for a price that is lower than its value.  That leads to two important conclusions.  The first is that you need to be able to ‘value’ an asset and secondly, price and value are two different things.

The next time you are at a dinner party, ask your fellow guests “what is an asset worth?”  Their response will usually be “what someone else is prepared to pay for it.” But common sense suggests this cannot be right and evidence also suggests otherwise.

In 1999 a company calling itself NetJ.Com listed on the OTCBB – a stock exchange in the US.  In its prospectus it stated that NetJ.Com conducted no substantial business activity of any description and that it had no intention of conducting any substantial business activity of any description in the foreseeable future.

It was a remarkably consistent business model – never done anything, not doing anything, not going to do anything.

The shares in this ‘business’ were offered to IPO ‘ínvestors’ for 50 cents each.  It may come as a surprise that the issue of shares was oversubscribed and on the first day of listing the shares traded around $2.00 each. By March 2000 the shares reached $8.88 before sliding to become 'worthless' (even though they were worthless much earlier) as the company was subsequently delisted.

Now if your dinner guests believe that an asset is worth “what someone else is prepared to pay” they must also believe that a company that did nothing was ‘worth’ $8.88 per share.  Clearly NetJ.Com was never worth $8.88.

So price and the value or ‘worth’ are two very different things.  Ben Graham said it most succinctly.  Price is what you pay and value is what you get.  Value investing is paying a lower price than the value you receive.

So how do you become a value investor in the share market?  The first thing that needs to happen is you have to think about shares as a piece of a business.  Then you have to understand the manic-depressive nature of market prices and finally you have to learn the correct way to value a business.

Most of the texts and newsletters on the latter subject unfortunately are wrong.  The 2-Stage model proffered by many analysts and texts such as The Warren Buffett Way double count cash flow – often resulting in unrealistic valuations (see our report by emailing info@clime.com.au).

It is also arguable that the Earnings Multiple Model suggested in Buffettology and used in various software packages and by some tip sheets cannot be a ‘valuation’ model at all.  If price and value are two different things how can you obtain a ‘value’ from a model when ‘price’ is one of the inputs in that model?

Encouragingly, value investing is simple but that does not mean it is easy.  Patience is a requirement and waiting for obvious opportunities is necessary.  Warren Buffett once quipped that the share market is a transfer mechanism, transferring wealth from those that have no patience to those that do.

Value investing is also a game where you don’t have to swing.  You can sit and wait for the ideal opportunities.  Macquarie Bank at $19.00, QBE at $4.00, Aristocrat at $1.00.  These opportunities don’t come about each day, but many so called investors feel the fear of missing out much more intensely than the fear of loss and so are programmed to be active every day. I would much rather sit in the safety of cash until opportunities presented themselves, than risk capital in unattractive investments.  Convincing our clients and shareholders of this when the market in aggregate is rallying strongly for two years is an entirely different matter.

As a private investor you do not have this pressure associated with short-term underperformance. There should be no excuse for buying something that you didn’t know the value of.  Look at the world’s best investors - Warren Buffett and Charlie Munger hold over $40 billion in cash, much of which is earning an even lower rate of interest than we can obtain here in Australia.  And it’s been that way not for weeks or months, but years.

Only good businesses should be valued.  Good businesses are those able to sustain high rates of return on incremental equity for many years, while employing little or no debt.  They also have capable management who understand how to allocate capital. 

The management of good companies never pay unfranked dividends in a year that capital is required and they understand under certain assumptions, that if they can generate a 20% return on equity, each dollar they pay out as a dividend has cost the shareholders a $2 capital gain.

To value a business there are several items of information you require.  The equity per share, the future likely return on equity the company will be able to generate, how those returns are allocated between dividends and retained earnings (yes dividends do impact valuations when the Rate of Return (RR) is different to the Return On Equity (ROE)!) and finally a discount rate.

We’ll round off this note with a simple valuation example.  More competent models are described in our Clime research notes. Lets begin with a few assumptions for the purpose of simplification. We’ll assume the government bond rate is 15%, there are no franking credits available, a company generates a 15% return on equity, pays all the earnings out as a dividend and the investor’s personal tax rate is 50%. 

Under these assumptions the company is worth no more than its equity per share.  In fact Equity per share is the MOST you would pay given that equity per share would equate your return from the shares to the return from the bonds. Bonds however have less risk than shares so the shares should ideally be acquired at a discount to this valuation.  For a company that pays all its earnings out as a dividend – effectively it’s a coupon paying bond, the valuation formula is ROE/Pre-tax RR * Equity per share. 

If you are interested in value investing find out more by reading our monthly NTA reports.  Our company code on the ASX is CAM. Alternatively, you can find out more by requesting our free research notes by emailing info@clime.com.au.

If you liked this article, you can also read Part 2 -  How to value a company's shares

(c) All rights reserved 2005. This article has been prepared by a third party and licensed to ASX. The views are those of the author and not necessarily of ASX. This material is educational and it is not intended to constitute financial advice. It has been prepared without taking account of any person's objectives, financial situation or needs and because of that, any person should, before making an investment decision, consider the appropriateness of the advice having regard to their objectives, financial situation and needs.

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