I am an engineer by training, so there is a part of me that constantly still look for numbers to justify my analysis. Naturally when I first read the famous “Security Analysis” by Benjamin Graham and David Dodd which many deemed it as the bible of investing, I was constantly looking for formulas that I can used in practice. I found the first formula that I use in investing right here in the book.
Here is it, the magic formula.
V = m[D + (E/3)] ± Asset Adjustment
V = Intrinsic Value
m = Multiple
D = Expected Dividend
E = Expected Earnings
The asset adjustment is only necessary when the result of the first part of the equation is more than twice the book value of the company. Armed with this formula, I stopped reading the book and rushed out to try to value all the company I can get my hands on. As you can expect, the story does not have such a great ending.
I gone through many mistakes which I would like to share with you so that you can skip the mistakes that I made and hasten your pace of becoming a better investor.
We often hear people saying that investing is both a science and an art. It is quite true and I have focused too much on the scientific aspect of investing with the formula and ignored the artistic aspect, which as it turns out was discussed in the later sections of “Security Analysis” which I failed to read the first time around.
I learn a few things from my experience with this formula.
- Companies without a dividend is almost impossible to value
Because the formula place such a strong emphasis on dividend, companies without a dividend are valued at such depressed price that it is almost impossible to find one that is trading below the estimated value.
- The formula place no value on growth
The formula looks only at the next expected dividend and earnings and did not look at the future growth potential of the company. Therefore, only companies with more predictable and consistent dividend and earnings are more suitable for this formula. Companies facing volatile earnings or huge growth are not reflected well through this formula.
- You end up buying many value traps
And because the formula valued companies with strong dividend highly, a company that is facing a structural decline that pays out most of its earnings as it has nowhere else to reinvest tends to have a high intrinsic value estimation. Therefore, if you are using the formula blindly and look into the prospect of the company, there is a real chance of you buying into value traps, companies that are no longer competitive and facing structure decline.
Value In Action
This is not to say that Benjamin Graham has taught us the wrong things. As I pointed out, the book discussed at length about how to evaluate management and the business at its later sections. The point here is we often see qualitative measurements more highly than quantitative assessments and that is a flawed thinking on our part.
In order for us to be a better investor, we have to thoroughly understand how to look at a business both qualitatively and quantitatively. The numbers aren’t everything, the sooner we realize that, the faster we grow as an investor.
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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and do not in any way represent those of his employer and other related entities. Stanley Lim does not own any companies mentioned.