Sep 21, 2010|
An investing misconception
We are sure that everyone, at some point of time in their investing career has faced this situation. You are thinking of investing in a stock, but you feel that the entry price is way too high. And, this is purely based on the absolute share price that the stock is trading at. This is assuming that liquidity is not of much concern to you.
Assets = Liabilities + Owners Equity
Case in point are companies like Orissa Minerals Development at Rs 26,261 per share or Dalal Street Investments at 21,634 per share.
Also Warren Buffet's very own Berkshire Hathaway Class A shares that last traded at US$ 125,160 per share.
Would you invest in your idol firm's shares? Maybe not.
To understand this situation we shall take a look at a few examples.
We will start with a simple question.
Suppose you were offered a pet bottle of Coke and one of Pepsi. The Coke is priced at Rs 500 for a 500 ml (millilitre) bottle. Pepsi is priced at just Rs 50 for the same. Which one will you choose and why?
If you picked Coke in this example you were effectively paying Rs 1/ml. And if you picked Pepsi, well you were paying a mere Rs 0.1/ml.
So, if you picked Coke, you were paying a hefty premium of 900% per millilitre for what was essentially the same sweet, black coloured liquid. Coke and Pepsi are close substitutes for each other. Here the price for Pepsi is definitely 'cheaper' than Coke. So let's hope that you picked Pepsi in this example.
Using the same example, let us now move on to stocks.
Let's now suppose Coke and Pepsi were both listed on a stock exchange. Let us assume that only their core business i.e. that of selling only Coke or Pepsi is listed. In reality, these are multi-billion dollar conglomerates, with holdings in restaurants, food, beverages etc. Let us also assume that they have the same level of management competence, same value of assets (plants) etc.
Coke was trading at Rs 5,000/share. While, Pepsi was trading at Rs 50/share.
Now, which one is 'cheaper'?
If you immediately answered Pepsi again, you might have to think again. This question is not as easy to answer as the last question. You cannot use the absolute value (i.e. share price) of the share to decide which one is 'cheaper' this time around.
Shares are in the most basic sense, the divided up value of the entire business of the company. The entire business is composed of assets and liabilities (including owners' equity) which have claims to the firms' assets.
In this example, we assume that Coke and Pepsi have no debt or liabilities, equal assets, and all these assets are completely funded by equity. Since, there are no other claims to the assets; the entire value is owned by the equity holders. But, what we have to understand is that this asset allocation to shareholders is on a proportionate basis. This is based on the number of shares that an investor owns. Not all companies have the same number of shares, however.
What we did not have in the example so far, was the number of shares the companies had outstanding. We are effectively paying for ownership in the company when we buy a share. In the famous words of Warren Buffet, "Price is what you pay. Value is what you get."
Coke vs Pepsi
|Value of assets
|Equity value (Market Cap)
Now, with the additional information, we can see that Coke is actually a 'cheaper' option.
Coke vs Pepsi
|Price per share (Paying) - A
|Assets per share (Receiving) - B
How is a Rs 5,000 share cheaper than a Rs 50 share? This is because even though the companies have the same asset value, one is trading at a discount to asset value, i.e. cheaper. So effectively by paying Rs 5,000/ share for Coke, you would be getting Rs 10,000 per share in assets, doubling the value of your investment.
While with Pepsi, by investing Rs 50, you are only receiving Rs 50 per share in assets. Since the both have the same assets, you would prefer to buy the cheaper option.
So now, let us hope you do not decide what is cheap or expensive based on only the absolute price, but rather on the value of the ownership or assets you are getting in the said company.
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