A big mistake investors can make when looking at individual securities is to value those securities based on just one metric. What I mean by this is that using a metric such as a price-earnings ratio as a shortcut for trying to understand whether or not a company is cheap or expensive can be incredibly misleading.
It does not matter if one uses the metric in isolation or in relation to other companies in the sector. Metrics that only take into account one key fundamental observation from a company should not be used as the sole method to understand value. In fact, relying on such an approach could cause losses, as it doesn't even come close to valuing the different types of assets that a company can have.
Understanding the drawbacks of simple ratios
While I pick on the price-earnings ratio above to make an example, I could replace it with any metric that fails to take into consideration every single aspect of a business, its operations, its past and future (which is to say, I could replace it with any metric).
The issue with these simplified metrics is the fact they are easily distorted. Take the price-book ratio, for example. This ratio compares the company's stock price to the overall value of shareholder equity. Some value investors use this as a shortcut to determine if the company is cheap or expensive.
However, the ratio does not tell analysts anything about the quality of the underlying assets, or whether they could really sell for what the company assesses them at. A company could mark a piece of machinery as being worth $10 million. Still, if it is a unique piece of machinery, which is unlikely to have a market anywhere else, it may be worth significantly less in the second-hand market.
This is just one factor that could have a significant impact on how much the company is really worth compared what a shorthand ratio says it is worth.
The issues of intrinsic assets
The shareholder equity value also gives no regard to intrinsic assets. Unfortunately, intrinsic assets are almost impossible to value. So, it is impossible to use a quick analysis to arrive at a value of how much they could be worth. Instead, one has to try and think carefully about the quality of the intrinsic asset and the cost of maintaining that asset.
This cost gets nowhere near as much attention as it should. The cost of maintaining a strategic brand such as Coca-Cola (KO, Financial) is not something anyone can really put an accurate value on. Although, it is possible to estimate the value of preserving this brand by looking at the total marketing spend the company lays out every year. This marketing spend gives some guidance as to how much to brand costs to maintain and how much it would cost a competitor to attack the market and grow market share.
Companies with significant intrinsic assets need to spend a lot of money maintaining these assets. As this is day-to-day spending, it goes through the profit and loss statement. On the other hand, companies that use tangible assets to generate returns, such as manufacturers, don't have to spend a lot on a day-to-day basis maintaining these assets. They have to purchase new machinery, but this is a capital outlay.
The only cost in the profit and loss statement is depreciation, although many analysts may ignore this factor if they concentrate on earnings before interest, tax, depreciation and amortization (Ebitda). Therefore, companies with lots of intrinsic assets have smaller balance sheets and different profit and loss accounts.
These factors mean that any simple ratios are completely irrelevant, and can in fact be misleading by merit of ignoring intangible factors such as brand and moat. Compared to a company with a high level of tangible assets, a company with lots of intrinsic assets will have higher spending levels. As such, it may deserve a higher multiple to compensate for the additional spending as well as the value of the intrinsic assets.
These drawbacks of the traditional valuation metrics may explain why value investors using traditional value criteria have performed so poorly in recent years in an environment where companies increasingly need to rely on intrinsic assets in order to become successful.
