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The correct way to approach investing - Views on News from Equitymaster
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  • Jun 18, 2009

    The correct way to approach investing

    In our last article we discussed one of the aspects of how one can view investing in stocks through the stock market with a business perspective, i.e. as if one were buying an ownership in a private business. Well, that's how some great investing legends who've racked up some really amazing investing performances over the years have confessed they think about stocks. Two of the most famous being Benjamin Graham and Warren Buffett.

    The last article revolved around how one could view the earnings of a stock/business with a business perspective, then going on to explain how the most common ratio in investing, the P/E ratio, could be viewed with that perspective. Now, let's go one step further to explore another facet of this basic but yet the most ignored perspective of investing.

    As an example, Graham once illustrated the investing attitude of investors in the days prior to World War I in the US, and how most of the investing public viewed buying stocks as taking a share in a private business. In those days, the typical stock market investor was a business man and so it seemed sensible to him to value any company in much the same manner as he would value his own business. The implication of this attitude was that he would give at least as much attention to the value of the assets behind the shares as he did to their earnings records.

    A private business has always been valued primarily on the basis of the 'net worth' as shown by its financial statement. A man contemplating the purchase of a partnership or a stake in a private undertaking will always start with the value of that stake as shown 'on the books,' i.e., the balance sheet, and will then consider whether or not the company's record and prospects are good enough to make such a purchase attractive. A stake in a private business may of course be ultimately sold for more or less than its proportionate asset value; but the book value is still invariably the starting point of the calculation, and the deal is finally made and viewed in terms of the premium or discount from book value involved.

    Broadly speaking, the same attitude was formerly taken while buying a stock through the stock market. The first point of departure was the book value, which is nothing but the total assets of the business minus its total liabilities (total debt). The book value signifies the amount of equity the owners of the business hold in the business. Hence, in considering a stock in the pre war days in the US, investors asked themselves: 'Is this stock a desirable purchase at the premium above book value, or the discount below book value, as represented by the market price?'

    That brings us to another important metric that every investor who seeks to invest with a business perspective should look at before taking a decision. It is the P/B (price to book) ratio. The P/B ratio tells one whether the company is selling at premium to its book value, at book value, or a discount to the book value. So if the share of a company is selling at 1 times book value, you would be paying an amount equal to the actual equity in the business. If it is selling at 3 times book value, you would be paying three rupees for acquiring every one rupee of equity in the business. The same is the case when the stock is selling at a P/B of 0.5, wherein you would be paying only 50 paisa for acquiring every one rupee worth of equity in the business.

    Now, exactly how many times one should be willing to pay for a share in a business depends on one's evaluation of the quality and prospects of the business. It is the hallmark of a wise investor to be acutely aware of exactly how expensive or cheap a price one is buying the business at as represented by a premium or discount to book value.



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