By MoneyMorning.com.au
You might be one of those investors who have been wondering whether now is a good time to look for cheap stocks. At a time like this – with the stock market breaking below 3840 this morning – it’s important to understand the difference between the intrinsic value and the price of a company.
This is something most investors simply can’t do.
When you estimate intrinsic value you’re estimating what a company’s really worth. It’s different to its share price, which is based on Mr Market’s emotional judgement – not rooted in sound knowledge of a company’s financial position or business fundamentals.
But that’s not to say the share price isn’t useful. It is. Because it gives you the chance to buy a company when it’s trading below its real value and sell it when it’s trading at a premium.
Put simply, price is what you pay and value is what you receive.
A stock’s price is based on the market’s assessment of its value. More often than not, this assessment is distorted by the prevailing sentiment – either too much optimism or pessimism. This means price and value often differ wildly.
And when you’re under the influence of sentiment, it can lead you to either buy a company well in excess of its value, or sell below its value. That is, fear and greed can lead you into making the wrong decisions at exactly the wrong time.
One tool I use in Sound Money. Sound Investments to help you see past the sentiment and assess whether a company is undervalued by the market is the price-to-book (P/B) ratio.
This is simply a way of calculating the value of the company’s assets against its share price.
For example, Lynas Corporation [ASX: LYC] is a rare earths miner. Today it’s trading at 93 cents. But back in April it was selling for $2.60 a share – the stock price has dropped 61%! What happened?
The volatility in the market hasn’t helped. But JP Morgan’s downgrade of fellow rare earths miner Molycorp [NYSE: MCP] was the real catalyst for the price fall. It started a big ball of negative sentiment rolling. Bankers, traders and retail investors began bailing out of rare earths stocks. They short sold the sector. All on the back of negative sentiment – the fundamentals for the rare earths market hadn’t changed. China still controls more than 95% of the rare earths market. Making matters worse, China is expected to offer a paltry 30% of its 93,800 tonnes of rare earths to the export market. And rare earth demand is tipped to reach 185,000 tonnes in four years.
But the power of this negative sentiment sparked by JP Morgan’s re-rating of Molycorp pushed the share price of Lynas deeper into the red. Even though the average price for Lynas’s assets – its rare earths – was up 31% in the third quarter!
Here’s the thing. Using the price-to-book value, you can see through the market sentiment and get a clearer picture of the company’s asset value.
Lynas has a P/B value of 2.98.
Now, for the value investor, a company with a P/B of less than one tells you one of two things. Firstly, it could be that the market feels the asset value is inflated. Or secondly, the company has a lousy return on its assets.
The higher a company’s profitability, the higher the P/B value will be. And at 2.98 Lynas is sitting pretty.
This is why I focus on profitable companies.
Over time, it’s a much lower risk way of building wealth than trying to chase the market up or bail out on the way down.
A company’s true value has nothing to do with sentiment. If you understand this and have the right temperament, you’re well on the way to becoming a very successful investor.
Greg Canavan
Money Morning Australia
