Ben Graham defines the costs of investing in being what you pay, and the value of an investment as being what you receive in return for your cost. Despite haven written an entire book on the topic of value investing, his entire philosophy can be summed up in that one phrase.
Value investing is about maximizing your tangible value against your real costs. One of the best ways to do this is to look at assets, and evaluate what physical goods you are actually purchasing as a portion of the company, and then determining if the value of the physical assets exceeds your purchasing price. Think of it like buying goods on sale. Since you will be stuck with these goods (at least on paper) in the event of insolvency, you want to be able to make a profit on being able to handle these assets yourself, because they are simply so undervalued that you could sell them yourself.
Below I’ve included details that describes the fundamental asset side ratio classes that you can use to evaluate the asset-backed value of your investment.
The quick ratio is a great starting point for when you’re evaluating a company. It outlines the value of the balance sheet in the event of immediate liquidation. It removes the company’s inventory from the proceeds, meaning that it essentially assumes that the company’s product is worthless.
This number will generally tell you the value of the company by the end of the month. However, it does not take into consideration whether or not your Accounts Receivables are of any real value. Realistically, AR can be extremely difficult to collect, and is therefore not worth as much as cash. To take this ratio even further, consider subtracting out the AR as well.
The Interval Measure serves to illustrate the length of time for which a company has enough short-term capital available to continue regular operations at its current level. By taking this measure into account, you are able to understand how long it would take for the company to start having to interrupt its daily operations, or selling off major assets to continue making money.
This essentially serves as an indicator of how robust a company’s operations are, as well as how long you as an investor would have to get out of a position during liquidation, assuming the security were to always trade at book value (note: it won’t).
Inventory represents how quickly a company is able to sell off its entire inventory. While this value adds some perspective to the inventory and cash flow metrics, it also demonstrates the effectiveness of a company’s marketing efforts. Increases in turnover after increases in marketing expenditures can signify a successful campaign. Additionally, this metric can show if there is an underlying opportunity for the company to expand its capacity, by representing the demand for the product.
The reason why we use the Costs of Goods Sold instead of the Sales (as some other investors might) is because the value of inventory will usually be recorded at cost. CoGs therefore gives us a more accurate number.
