“When you buy a stock, get in the mental state that you would own the whole business. Think about what you would pay for the whole business” — Warren Buffett
Let me show you why following Buffett’s advice will make you a better investor and could save you from some costly mistakes.
It’s perhaps natural that as small shareholders we tend to focus on ‘per-share’ numbers. We’ll look at the dividend per share, multiply it by our shareholding and calculate how much income we’re due. We’ll likely use per-share numbers and share price to calculate the dividend yield and price-to-earnings (P/E) ratio, helping guide our decisions on buying and selling. We may look at price charts which, of course, also present per-share data.
However, here are some examples of how taking a whole-company view can provide a more useful perspective than a per-share focus.
I’m sure there’ll be some investors who have looked at Lloyds’ 65p share price today and idly wondered if it might one day get back to the 575p it was trading at this time 10 years ago, before the financial crisis.
Looking at the whole company puts this question sharply into perspective. Back in February 2007, Lloyds had 5.6bn shares in issue and at 575p the market cap was £32bn. Today, although the share price is just 65p, there are 71.4bn shares in issue, making the market cap £46bn. So, Lloyds is already valued considerably higher by the market now.
If the shares were to trade at 575p today, the market cap would be a gargantuan £411bn, making domestic Lloyds by far the biggest bank in the world — £150bn more valuable than global giant JPMorgan Chase.
Pause for thought
BT provides a less extreme example than Lloyds, but one that should still give us pause for thought. Following its recent troubles, you may have read that the company’s shares (at a bit above 300p) are trading at their lowest level since mid-2013. However, although the share price is the same, BT’s market cap is £6bn higher today, largely due to shares issued in connection with the company’s acquisition of EE.
Again, a whole-company view adds to our perspective, alerting us that we need to consider a little more than that BT’s shares are trading at their lowest level in almost four years.
The important matter of debt
Finally, thinking about what we would pay for the whole business focuses us on the important matter of debt. Enterprise value — market cap plus net debt or minus net cash — is the theoretical price we would have to pay to acquire the whole business on a debt free/cash free basis.
The usefulness of considering enterprise value is illustrated by what happened at oil producer Gulf Keystone Petroleum last year. After releasing its annual results on 17 March, the shares, which had been in decline for some time with the falling oil price, dropped below 10p and the market cap fell to £92m.
Many investors averaged down, arguing that the company had valuable assets and a bidder could easily pay twice £92m or more. However, Gulf Keystone also had net debt of £338m, making the enterprise value £430m. No bidder was interested at such a price, the shares fell further and a restructuring left shareholders nursing massive losses.
More tips on better investing
Taking Buffett's advice to consider what we would pay for a whole business can save us from some, but not all, investing blunders. With this in mind, the Motley Fool's experts have published a FREE report called The Worst Mistakes Investors Make.
G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.