Monday, January 08, 2007
Why is a dollar worth of A is different from a dollar worth of B?
Is a dollar of asset worth in A the same as a dollar of asset worth in B? In all businesses, asset classes and investment types, the ability for each of the different asset of generating future value worth of earnings varies, even though on paper both are carried at equivalent worth.
In traditional Benjamin Graham's method, one of the principles is to buy a business at less than a dollar worth which is carried on paper. That is, for every dollar worth of asset, you must not pay more than a dollar in order to have a margin of safety. However, many times, this principle can be very misleading in the sense that many such deals could be a "cigarette-butt" kind of business. Imagine if you pick up a cigarette smoked almost to the tilt by the sidewalk, you can perhaps take a last puff out of it and nothing more. It may appears cheap but it will not last. And that's pretty much it.
Let's assume A to be government bond and B to be a stock equity or a private business available for sale. In a government bond, if you invest a dollar, it is represented on paper as a dollar. In other words, the price-to-book ratio in bonds is 1.
Whereas in stock equity or a private business, it is not neccessarily so. Sometimes, the stock price is worth less than what is carried on paper, sometimes, it is more, and some other times, it is equal.
From the above, we can deduce that a dollar carried on paper is just an arbitrary figure and gives no meaningful deduction as to what the dollar can generate in terms of output in the future.
The next question to ask is what is the actual value of a dollar worth in each different asset class that you should pay for. In other words, what ratio an investor should pay in relation to what a dollar of asset is carried on paper.
For example, if you have a dollar to invest in either bond or a business, which will be the better option? To determine the better option, another fact is a dollar invested in bond is carried on paper as a dollar. While a dollar invested in the business is carried on paper as 25 cents.
In this example, if you follow strictly on Graham's theory, you'll never pay each dollar for every 25cents worth of assets. But here, Graham missed an extremely vital point in which every asset is very different in nature. For example, a residential or commercial property asset that is worth $1M is very different from a million worth of Coca Cola's plant and equipment. A more clearcut example is if you buy a dollar worth of Louis Vuitton handbag, immediately, even if you do not use it and want to resell on the market, it'll be worth at $0.70.
Thus, for a pure Grahamite, between investing in bond or in the business, the obvious choice is to go into bonds. So let's fast forward to 20 years later to see the result between these two asset classes.
In bonds, for every dollar invested will be worth $2.78 at the end of a 20-year period at an interest rate of 5.25%. On the other hand, in the business, a dollar paid for every 25cents worth of the business asset will grow to be worth $8.11 worth of assets at the end of the 20 years, assuming the return on equity of the business is 19%.
Hence, what is clear here is the 25cents worth of asset today is worth far more than the dollar worth in bond. So paying a dollar for every 25cents in the business is a far superior investment than to pay a dollar for every dollar of bond.
And if we discount both values of the business and the bond at the end of the 20 year back to the present value of today at an inflation rate of 2.2%, the present value of the business is worth $5.13 and the bond is worth $1.76, respectively.