April 05, 2016

How We Measure Matters

Quite often in the process of making a decision, we commence without properly considering the underlying assumptions we use to measure our progress, or our perception of the situation at present.

How we think and perceive is crucial to our decision-making process, and as our thoughts and focus are often influenced by those around us, we might easily adopt the way others think and measure. This is particularly hazardous to do when everyone is using the same method to measure. Though there is much comfort in thinking like everyone else, it does not always lead to the right decision.

Group-think is common in many areas of life, and brings with it particular consequences to the realm of accounting and financial decision making. The manner in which we think about financial decisions is in part formed by accounting standards, and as such, investment decisions must be founded on a better understanding of these assumptions. Accounting doesn’t always accurately reflect a firm’s position, and inaccurate assumptions are often perpetuated by the media. When headline profit and loss figures are reported and blown out of proportion, there is often a failure to recognize factors such as sunk costs or temporary losses, or an overemphasis on the P&L rather than the balance sheet.

Consider a hypothetical scenario in which a company makes no profit. According to some methods of measuring its value, from common wisdom to the price-earnings ratio, it would appear to be worthless. Yet that same company may have significant assets on its balance sheet that are of worth, though are ignored based on a single method of measuring value.

Such was the case with Billabong, which was declared by one analyst as having the worst PE ratio in the market. However, the balance sheet revealed actual stock on hand to be worth more than the value of the share price, not to mention the inherent value of the brand, and an underlying successfully operating business. The market was preoccupied by the write-offs on the P&L.

Another example was the Australian Education Trust (now trading as Folkestone Education Trust), which was sold down to a fraction of its NTA due to its main tenant ABC Learning going into administration. However, the trust held the properties occupied by the ongoing business, in addition to the underlying value of the land.

Scenarios like these can occur when the popular consensus is that income is always a reflection of wealth. But wealth can be better quantified, and as such, these situations can create opportunities to take advantage of the mispricing caused by the manner in which we measure the value of an asset, as opposed to its true worth.