The Business of Value Investing.pdf

Avoiding Common Stumbling Blocks 231

an investor still hasn ’ t lost any money from the original $ 18 pur-

chase price. These are not scientifi c assumptions, but nonetheless,

they are effective in illustrating the value of growth and why value

investors prize businesses with the ability to maintain sustainable

growth over extended periods of time.

The PEG ratio is considered to be a convenient approximation.

It was popularized by Peter Lynch: “ The P/E ratio of any company

that ’ s fairly priced will equal its growth rate ” — that is, a fairly valued

company will have its PEG equal to 1.^3

Businesses without Current Earnings

The price to earnings (P/E) ratio is generally a sound metric but

can be useless if a business currently has no earnings. The consid-

eration for investment in this instance is not diametrically different

from a company that is actually profi table. Prudent investors realize

that any business can go from being unprofi table to profi table and

vice versa. Obviously since there are no earnings, reliance on the

P/E ratio is out of the question. In such cases, value investors will

expend their efforts on examining the balance sheet, giving care-

ful attention to the assets and assessing whether the business can

become profi table. Even more important is to determine how soon

this profi tability will be achieved and whether that profi tability can be sus-

tained. The extra focus on the balance sheet helps quantify a margin

of safety in case achieving profi tability takes longer than expected

or, in the worst case, profi ts fail to materialize. Paying $ 5 a share

against a company book value of $ 15 a share can minimize capital

loss if a business is forced to liquidate or put itself up for sale.

In many situations, it may be far more advantageous to invest in

temporarily unprofi table businesses, if you are confi dent after rea-

sonable research and analysis that the business will regain and retain

profi tability. Unprofi table businesses may be trading at signifi cantly

depressed prices due to the short - term tendencies of many market

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