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One Ratio Warren Buffett Used To Love

The father of value investing, Benjamin Graham, pioneered the idea of investing by evaluating net asset value of a company, also known as net-nets.

Since then, many investors have adopted the Net-Nets investments approach, including Warren Buffett who used the investing method successfully in his younger days. There may be some merits that could benefit us.

Here is a simple illustration of the use of Price-to-Book (P/B ratio).

Say you purchased a vending machine selling soft drinks for $1,000. I come along and offer to buy the business at $500. Because you paid $1,000 and the offer is $500, my offer is at a P/B ratio of 0.5 (500 divided by 1000).

That offer may be too low for you, since you paid more for the vending machine. You decided that you want $2,000 for it. That is P/B ratio of 2. Clearly, the cheaper I can get the vending machine or business for, the better the deal is for me.

Graham believed that buying companies for below book value could lead to a good investment return. His approach focused on the hard assets (vending machine) and less on the business that goes with it (selling drinks).

While buying a company at low P/B makes sense, a low P/B alone does not guarantee a good investment. Here are a few examples why.

Beyond P/B ratio

Consider Qian Hu Corporation Limited (SGX: 552). Qian Hu breeds and sells ornamental fish, in particular the highly priced Arowana. Currently, Qian Hu trades at P/B of 0.42 times and a dividend yield of 2.2%, making it a plausible investment target for investors looking for undervalued asset.

Let’s go a step further. Qian Hu has delivered a 1% return on asset for past 12 months. To illustrate return on assets, let’s use the vending machine example, again. Let us assume the vending machine makes a profit of $10 per year. Since we paid $1,000 for our asset (vending machine), it would be a return on asset of 1% (10 divided by 1000).

Would buying a vending machine at a P/B of 0.42 (Qian Hu’s current PB ratio) or $420, for $10 profit per year sound like a good investment? If you leave the same $420 in CPF at 2.5% interest rate, you will have earned $10.50 of interest, almost risk-free. Buying an asset cheap does not necessarily mean it is a good investment.

On the other end, Vicom Limited (SGX: V01) is trading at a P/B ratio of close to four. For the Graham-style investor, such a company will probably never come under the radar. However, the test and vehicle inspection unit has generated a consistent return on asset of over 14% for the past five years.

Let’s go back to our vending machine example again. At P/B of four, we will buy the vending machine business at $4,000. That is a $3,000 premium over the purchase price.

But suppose the vending machine makes a profit $140 per year. Since we paid $1,000 originally for our asset (vending machine), it would be a 14% return on asset (as in Vicom case). Even with a much higher price tag of $4,000, the yearly returns is still 3.5% (140 divided by 4000), which is better than Qian Hu’s returns.

Foolish summary

Investing has evolved since the days of Graham. Back then, to pick net-nets companies, one had to literally lay their hands on the annual report and figure out the P/B ratio. With the abundance of information available today, such bargains may be harder to find. To better gauge if the company is undervalued based on P/B value, it may be better to consider evaluating the return on asset as well.

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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 contributor, Wilson Ong, doesn’t own shares in any companies mentioned.