If the price is not right ::

Author: George Liondis
Date: 01/12/2006
Words: 466
Source: FSI
Publication: Financial Review Smart Investor
Section: News
Page: 10

What you pay for a stock can have little to do with what it is worth. Sometimes, it's better to ignore price. George Liondis explains.

It probably goes against everything you thought you knew about investing, but a company's share price is one of the least useful ingredients you can consider when valuing a stock.

At least that's the viewpoint of a growing number of investment professionals, led by Clime Asset Management managing director Roger Montgomery.

Montgomery's basic argument is that price, and, therefore, the price-earnings ratio is not a good measure of fair value in the sharemarket.

"P/E has nothing to do with value," Montgomery says. "P/E ratios are a reflection of price, not value. Price is what you pay for an asset, not the value you get."

Montgomery's alternative is to value stocks based on five factors: the ownership structure of the company, the equity in the business, the rate of return on that equity, how that rate of return is distributed (dividends) and, ultimately, each individual's expectation of what they want from the investment.

To highlight the different outcome his formula produces, Montgomery points to ABC Learning (ABS). The child-care centre operator is trading at about $7.00, but Montgomery says his approach values the stock closer to $3.00.

"People say an asset is worth what people are willing to pay. But that's not true," he says.

Montgomery is particularly scathing of those who argue that the Australian sharemarket is not overvalued, even after the record run of the past few years.

"Those people are looking at average P/Es," he says. "It's like sticking my head in the oven and my feet in the freezer and saying my average temperature is okay."

State Street, one of the biggest index fund managers in the world, is also campaigning against price as the underlying criteria for valuing stocks.

The fund manager's main beef is with sharemarket indices, on which it builds its investments. Traditional indices, like the S&P/ASX 200, include companies based on market capitalisation, which is calculated by multiplying a company's share price by the number of shares on issue.

But State Street argues that the inclusion of a share price component in the equation is problematic because it means companies that are overvalued end up in an index, while those with better investment fundamentals, but which might be out of favour for one reason or another, do not.

It is on a mission to create indices that include companies based on fundamental financial data, such as earnings and cash flow, rather than a stock's price.

Does all this mean we should be ignoring price when buying shares? Of course not. But it does mean that when you are trying to assess the value of a stock, there are other things to consider.

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