Columns Z & AA – Price to Book Ratio

Cameron : Yeah. And then column Z is the price to book ratio. Another formula, this one is the share price minus NEPS, divided by NEPS. This is giving us a ratio for the next column, column AA which is the question that you were indicating a few seconds ago: Is the share price less than 30% above NEPS, the net equity per share? This is another score cell. Now this is what you’re saying, ideally, we don’t want to pay any more than 30% above the share price. This is more safety margin stuff. Why the 30% figure? Is there any science behind that or is it more black magic?

Tony : It’s not black magic. It’s another steal from Warren Buffett who has always said that he would be interested in buying back Berkshire Hathaway shares if he thought that they were trading at less than 30% of book value.

Cameron : And did he say why 30%? Is it just about risk margin?

Tony : I think it was partly risk margin, but partly also because of all the intangibles, etc. It can be a difficult thing to nail down book value if you drill right down into it. So he’s just giving himself a bit of a buffer there.

Cameron : It’s the Buffett buffer! So, if we’re going to buy a dollar’s worth of equity, we don’t want to spend much more than a $1.33. Again, it’s just about minimizing the risk. We’re asking: how much are we paying for this thing? We don’t want to overpay. When I was with you in Sydney recently, you were using the example of buying a car and how you like to negotiate the price before you buy anything. And you said shares are exactly the same. There are two parts to QAV – the quality and the  value. You want to buy a good quality stock, but you don’t want to pay too much for it. The car analogy would be something like going to buy a Mercedes-Benz. Let’s say the sticker price is $100,000. You don’t want to pay $200,000 for it. Why would you do that? Why would you pay twice what something is worth? That’s ridiculous. When it comes to shares though, people quite often don’t have the mindset of determining the intrinsic value of the share. As a result, they will quite often over pay for something.

Tony : Exactly. And look, I think there’s a school of thought in investing that paying anything for quality is a good investment because the company will keep going up, its share price will follow, and over time you get your money back. I don’t subscribe to that and I don’t think anything is worth over-paying for, even if it’s the best company on the share market.

Cameron : One of my favorite quotes is from Howard Marks at Oaktree. He says, “figure out what something is worth and then try to buy it for less”.

Tony : Exactly.

Cameron : And I think he also says “buy shares like you buy everything else – when it’s on sale”.

Tony : Yes. 

Cameron : Which is of the discipline of investing value investing, right? Only buy it when you can get a good deal.

Tony : Yup. Everything is value investing if you look at it that way, but a lot of people don’t think like that with the share market for some reason. For all sorts of human psychology factors, like their mates have made money out of investing in a tech stock, so they don’t want to be left behind. So they go and buy it too. All the sorts of mistakes I made in my first year of investing.

Cameron : The fear of missing out. Greed and emotion is what drives the market. We’re trying to be more scientific than that.

Tony : Correct. We’re trying to take the emotion out.