Modern Security Analysis: Net Asset Value (Part 8)

“…in the hands of an astute management an overpriced common stock can be a most important asset.” —Whitman & Diz, Modern Security Analysis

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1• The Graham and Dodd View on NAV
• The Financial Accounting View on NAV
• Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
• NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
• Limitations of NAV in Security Analyses
Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
• Net Nets Redefined
• OPMI Investing in Companies with Growing NAVs Summary

Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE

When common stocks are selling at ultra-high premiums over book value, it is hard to acquire securities at reasonable P/E ratios. This can only be accomplished if the issuer enjoys unprecedently high returns on equity (ROE), say well in excess of 30 percent. In fact, most companies rarely achieve ROEs in excess of 25 percent most of the time. In our recommended list of common stocks in Table 6.11, the goal for the issuer, as measured by ROE is to achieve growth of 10 percent per year after adding back dividends, over a 3- to 7-year period.

The above can be demonstrated by a simple example. Assuming a market price of 6× book value, P/E ratios at various ROEs would be as follows:

MSA6_8

The 6× book value might be justifiable assuming that a company has such attractive access to capital markets that it could increase their number of shares outstanding by 31.5 percent via the issuance of new shares at 5.25× book either in an acquisition or a public offering. (This assumption is probably unrealistic for most companies most of the time.) In that instance book value would increase to $2.02 per share,[11] and EPS and P/E ratios would be as shown in Table 6.9 for various ROEs (forgetting the probabilities that the increased equity base might well precipitate a decline in ROE). This is part of our thesis that in the hands of an astute management an overpriced common stock can be a most important asset.

MSA6_9

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[11] Since the new number of shares relative to the old number is 1.315, the proportion of old shares at a book value of $1 is 1/1.315 or 76 percent, while the proportion of new shares priced at $5.25 is 24 percent. The new book value per share is calculated as (0.76*$1+ 0.24*$5.25), or $2.02.

MSACoverDisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

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