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The Importance of Understanding Where the True Value of A Company Lies

There is a saying that goes like this: “To a person with a hammer, everything looks like a nail.”

It is a saying that we, as investors, need to keep in mind. That’s because it’s often the case where we end up using one analytical method to pick through all types of companies we come across.

That practice can be quite dangerous because the true economic value of one company may be found in a completely difference place from another firm. Only by understanding where true value can be found can we make informed decisions on whether a share is a good investment at its prevailing price.

When book values don’t make sense

I’d like to illustrate the hammer-and-nail problem by using Singapore Post Limited (SGX: S08) as an example. At its current share price of S$1.945, the postal and logistics services outfit has a price to book (PB) ratio of 4.

To investors who focus only on a share’s book value (total assets minus total liabilities) in their search for bargains, Singapore Post, with a PB ratio of 4, would offer no real value at all; I’ve met and spoken to my fair share of such investors.

But, in my opinion, the true value of Singapore Post lies not in the hard-assets (properties and logistical equipment etc.) it has on its balance sheet, but on the strong logistical network in the Asia Pacific region that it has built up over the years.

Not many competitors would be able to duplicate the reach that Singapore Post has. This means that the company is one of the few in the region that has the ability to meet the logistical needs of an e-commerce giant like Alibaba Group.

That may also be why the China-based Alibaba chose to make an investment of more than S$300 million into Singapore Post in the middle of 2014; Alibaba needed a partner with a strong distribution network. So as you can see, Singapore Post’s book value on its balance sheet has little relevance to its true worth as an ongoing business.

When book values make sense

On the other hand, real estate investment trusts are basically property owners that rent out their properties to tenants. Therefore, the book value of REITs – of which Suntec Real Estate Investment Trust (SGX: T82U) and Frasers Commercial Trust (SGX: ND8U) are just two examples – will have a much stronger relationship with their true economic worth.

At their current prices, Suntec REIT and Frasers Commercial Trust have PB ratios of 0.88 and 0.92 respectively.

Foolish Summary

To summarize, it is important for us to analyse a company by first figuring out the true sources of its economic value.

If not, we might end up using just one metric – such as the book value – to evaluate the investment-worthiness of all types of companies out there even when some companies’ true economic worth might have no real relevance with the metric we’re using.

For more investing analyses and important updates about the financial and stock markets, sign up for The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim does not own any companies mentioned above.