The development of the stock market in recent decades has made the typical investor
- more dependent on the course of price quotations and
- less free than formerly to consider himself merely a business owner.
The reason is that
the successful enterprises in which he is likely to concentrate his holdings
- sell almost constantly at prices well above their net asset value (or book value, or “balance-sheet value”).
- In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.†
This is a factor of prime importance in present-day investing, and it has received less attention than it deserves.
The whole structure of stock-market quotations contains a built-in contradiction. - The better a company’s record and prospects, the less relationship the price of its shares will have to their book value.
- But the greater the premium above book value, the less certain the basis of determining its intrinsic value—i.e., the more this “value” will depend on the changing moods and measurements of the stock market.
Thus we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. - This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.*
- (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)
† Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities.
It can be calculated using the balance sheets in a company’s annual and quarterly reports; from total shareholders’ equity, subtract all “soft” assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.
* Graham’s use of the word “paradox” is probably an allusion to a classic article by David Durand,
“Growth Stocks and the Petersburg Paradox,” The Journal of Finance, vol. XII, no. 3, September, 1957, pp. 348–363, which
compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an investor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share?
Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows, and the higher the cost of even a tiny miscalculation becomes.
Ref: Intelligent Investor by Benjamin Graham
