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Thursday, March 27, 2008

Investment - Key Metric

Posting an email response that I sent out recently(italicised phrase are for clarification) for a question on my previous post on TDYT:-
As an investor, I am interested in what I term "Real RONW". I define it as the Return on Net Worth (RONW) I get by investing at the current price. Let's say you have a business earning 30% RONW currently and it trades at 3 times book value, as an investor my real RONW will be 10% (30%/3). This is an indirect way of coming up with an accounting goodwill calculation. Usually I compare the real RONW to the expected yield on stocks/bonds to decide whether to do further research on the business. Let's say I am buying a significant stake in this business, the way I would pay (assume market price USD 30 per share), USD 20 as goodwill and USD 10 would be the net equity in the books on consolidation. At the end of a year, the business (assuming the business earned at the same rate) earns the same return, I would increase the net equity by USD 3 (30% of USD 10 Net Worth or 10% of USD 30, the price). As a result, even though the business earned 30% on its networth, I earn only 10% because I paid 3 times the book value.
For TDYT, I didn't have to go into this whole exercise. It was a screaming buy, just because of the P/E and the fact that management reported in 10k that their true value was somewhere close to USD 2.50. The more than 40% calculation was just the inverse of P/E (P/E was a little over 2, if I remember correctly). I also realised that the business was facing strong headwinds because of its presence in the housing market. This was one of the reasons I was looking at it as a short-term trade than a long-term buy.
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