The Investor's Dual Status and Business Valuation Principle

Key Insight

A shareholder has a dual identity: a part owner of a business, whose value depends on the enterprise's profits and assets, and a holder of a marketable security, whose price fluctuates momentarily on the exchange. Historically, investors often found the market price to diverge greatly from the underlying balance-sheet value, especially with successful enterprises frequently selling far above their net asset or book value. This reliance on market premiums makes investors dependent on the stock market itself to validate their commitments.

A significant paradox exists in stock valuations: the more impressive a company's record and prospects, the less its share price tends to relate to its book value. Consequently, a greater premium above tangible assets means the 'value' becomes more dependent on changing market moods, making the 'better' quality common stock potentially more speculative in price behavior. For example, International Business Machines (IBM) saw its share price fall from 607 to 300 in seven months (1962-63) and from 387 to 219 in 1970, while Xerox dropped from 171 to 87 (1962-63) and 116 to 65 in 1970, despite strong long-term growth prospects.

For conservative investors, it is best to focus on issues selling at a reasonable approximation to their tangible-asset value, ideally not more than one-third above this figure. Such purchases are logically supported by the company's balance sheet, offering a justification independent of fluctuating market prices. Beyond asset value, a sound investment also requires a satisfactory earnings-to-price ratio, a strong financial position, and expectations of sustained earnings. This criteria was met by over half of DJIA issues in 1970, with American Tel. and Tel. selling below its tangible-asset value and many light-and-power shares available near asset values in early 1972.