I was reading an article a few days ago which asserted that emerging markets equities were overvalued because they were trading at an average of 2.3x book value vs. an average of 1.8x book for stocks in developed markets.
What does this mean? Is the argument a reasonable one?
I’m going to cover this topic in two posts. This one will outline what book value is and the sorts of circumstances where I think it’s useful. In the second post, I’ll talk about situations where book value is more problematic as a value indicator.
What “book value” is
“Book value” is the value of the shareholders’ investment in a company as shown on the company’s official records, or “books”.
For reporting the condition of their client companies to stockholders, accountants produce three basic records:
the balance sheet,
the income statement and
the cash flow statement.
Book value comes from the balance sheet.
The balance sheet has two sides. The entries on each side add up to the same number, or “balance” with each other. One side lists everything the company owns, from cash, to inventory and receivables, to plant and equipment. The other has liabilities–loans, preferred stock, credit extended by suppliers and anything else the company owes to others–plus common shareholders’ equity. Book value is what’s left after subtracting liabilities from assets. It’s another name for shareholders’ equity.
Why it’s useful
Book value is a very basic and traditional measure of value. It functions in several ways:
1. liquidation value. If we assume that the accounting statements are accurate, book value per share is the amount that stockholders would receive if the company’s assets were sold in an orderly way, liability holders paid back, and the remainder distributed to owners. A company whose stock trades at a steep discount to book value is, at least in theory, under threat of being taken over and liquidated, if its results can’t be improved by the new owners.
2. a shorthand way of assessing management’s capabilities. In combination with profit data, we can use book value to calculate ratios like return on capital (annual profit/debt + book value) or return on equity (annual profit/book value). Years and years of all the data needed for these calculations are available in databases, so companies can be screened and compared very easily. Comparison can either be across a universe of stocks or for a single company over different periods of time.
If we assume that the specific assets a company owns don’t carry with them a unique advantage over competitors, then variations in return on capital across an industry are most likely due to differences in management quality. If the analysis is confined to a single industry, the highest results can at least show what returns can be achieved by strong management–and therefore what improvements are possible among laggards.
3. a guide to stock market valuation. Another way of looking at book value is that it’s what it would cost to reconstitute a given company by buying similar assets and taking on similar liabilities. By this measure, a stock trading at a discount to book value should be cheap. Conversely, a stock trading at a premium to book should be expensive. One of the rules Benjamin Graham, the father of value investing in the US, used to use was that a stock was potentially attractive if it traded at below 2/3 of book value.
A corollary of #1 and #2 is that a company whose stock is trading at, say, 2x book because returns are very high is likely creating an artificially high pricing umbrella which will draw competitors to the industry, eventually undercutting the “expensive” firm’s profits.
Because you’re only looking a one simple variable, it’s possible to screen large numbers of companies in an instant, as well as to compare firms in different industries with one another.
Advocates would also argue (this is not a majority view, however) that there’s no chance of being seduced into buying overvalued stocks by smooth-talking managements with fancy powerpoint presentations. You’re dealing with hard, cold facts–the numbers.
What you need to believe
The basic assumptions you make when using book value as a tool are:
1. when a company buys long-lived assets like property, plant and equipment, or makes a long-term investment in another company, it basically gets its money’s worth–in other words, the purchase price recorded is a fair assessment of value,
2. while there may be differences in the bells and whistles decorating a given factory or the manufacturing equipment located inside, these assets are functionally equivalent to superficially different assets competitors may hold–so a comparison of carrying values is legitimate,
3. these assets have enduring value that, if it changes, does so only slowly–so carrying value doesn’t lose its relevance as time passes,
4. the auditors are doing their job of ensuring that the company writes down the carrying value of worn-out or obsolete assets,
5. something can and will happen with a company trading at a deep discount to book to force the stock price up so that the discount disappears- in other words, action will be taken by shareholders, the board of directors or outside activist investors, to achieve this result.
Under these assumptions, then, when you locate a company whose stock is trading at a big discount to book, you’re looking at a deeply undervalued–and very attractive–security.
One other thing. The industry itself must be viable–no buggy whips or whale oil processing. In today’s world, many book value-guided value investors avoid airlines for this reason.
The basic metaphor
The basic metaphor is a manufacturing one. A company has valuable tools that it employs workers and managers to utilize. Assets are seen as commodity-like.
Firms are seen as achieving a competitive advantage by having been able to obtain enough capital to buy its productive assets in appropriate size the first place, and by achieving economies of scale by operating them efficiently and reinvesting profits in their expansion.
Where it works
Since the idea behind using book value as an investment tool is industrial, it makes sense that it should generally work best for companies that produce goods, not services.
The concept is useful in evaluating a very wide range of companies, from general industrials to oil refiners or cement makers or shipyards (or ship owners), or office buildings–to name a few. Anything with physical assets.
It applies especially well, I think, to manufacturers of semiconductors, computer components and other IT hardware. How so? The industry is very capital intensive. The companies in question are all relatively young. Their plant and equipment has been purchased in the recent past. As a result, the playing field for comparison is level and the figures are probably highly accurate. There’s little chance of making an apples-to-oranges comparison between brand new plant carried at full purchase price and perfectly adequate plant bought at lower prices twenty years ago and already partly depreciated.
Book value has also been the tool of choice for assessing financial companies, especially brokers and other trading companies. Results using book over the past few years have, of course, been disastrous–Bear Stearns had reported book value of above $80 a share just as is was collapsing.
The idea was that it’s impossible to understand, transaction by transaction, what is going on inside any financial company. But what they do is invest shareholder’s money. The money they have to work with is book value. What an investor can do, however, is calculate the return a company achieves on book value. If a company consistently earns, say, 20% annually on book, I can pay up to 2x book value for the stock–getting me a 10% earnings yield. If the return is a Goldman-like 25%, then I can pay 2.5x book
What happened to the financial industry was, I think, not so much an indictment of the use of book value as it was an indictment of managements and auditors who used dubious accounting tricks to present a grossly distorted picture of their firms.
What about intangibles?
It may be that a company gradually builds up a reputation for quality and service that allows it to charge premium prices for its goods. This will presumably translate into higher profits and a stock price that substantially exceeds book. Won’t a book value screen toss out a firm like this?
1. You can use the trading history of this sort of company’s stock vs. book value to judge when it it may be time to buy during a downturn or to sell during an upturn. The idea would be that the stock has never in the past traded below .9x book in recession, so when it hits that level in a downturn it’s pretty safe to buy. or that it peaks at 3x book in an upturn.
2. If you’re worried about this, you’re not a value investor–who are the primary users of book value as a tool. Value investors argue that the real money, and the low-risk money is going to be made by finding the laggard company in the same industry that’s trading at a deep discount to book. When the board of directors or activist investors force a change of management in that company, and when the new management works the company’s assets harder, the profits will soar (at least to the industry average and maybe beyond) and the stock will skyrocket. That’s where you should be looking.
That’s it for today. My second post will talk about situations where one has to be careful about using book value.
referring this sentence, I would like to know – how did u arrive at this number 2x for 20% ROE etc. Can you throw some light on that.
“If a company consistently earns, say, 20% annually on book, I can pay up to 2x book value for the stock–getting me a 10% earnings yield. If the return is a Goldman-like 25%, then I can pay 2.5x book”
In India, there is one company MTNL (telecom company with zero debt) which is available for cash (on books) and 50% of book. But the net profits have plummeted to INR 1680m from INR 9800m since last 5 years despite sales are constant. (primary reason being fierce competition in Indian telecom market – price cuts and all.
Many of these telecom companies are now going to bid for 3g licenses, so I presume that some cash would be used for that purpose. I was wondering about investing in that stock. (business-wise I think its bad company to invest in, but if the management is sensible enough of not squandering cash; lying around since 3 years, should it be good stock to invest in.
awaiting ur thoughts on this.
Thanks for your comment. Book value, or net equity, is the money that the management has in its hands to invest for shareholders. It comes either from the proceeds of stock issues, or more commonly from profits retained in the business (rather than paid to shareholders as dividends). Book value is a basic tool for value investors. For me, it has its greatest usefulness either in capital intensive businesses, where the ability to invest large amounts of money in plant and equipment, or in commodity businesses like finance, that are too complex for an outsider to understand the details of.
Let’s say that in a given set of economic circumstances, a company management shows that it can consistently earn a 10% yearly profit on shareholders’ money and that a share of the company’s stock trades at 1x book value/share. That’s a PE of 10 and an earnings yield (1/PE) of 10%.
I’ve assumed, probably without making it clear, that a 10% earnings yield is what investors expect to get from investing in stocks. In other words, investors expect a company to earn yearly profits equal to 1/10th of the stock price.
If so, what can we say about a company in the same industry, with a similar asset composition and risk profile, but whose management consistently earns a 20% annual return on shareholders’ money. If this stock is priced to achieve a 10% earnings yield, then the stock price can’t equal book value. 20% of (1x book value) is equal to 10% of (2x book value). So the stock should trade around 2x book value. In reality, the market won’t believe that the company can achieve above-average returns forever and won’t give it full credit for the performance it is currently achieving.
I’m not any help on MTNL. I haven’t looked at the company for well over ten years (a little scary that it has been that long). Three points, though.
I may be misunderstanding your third paragraph, but you could be double counting MTNL’s cash. Book value = Assets (including cash) – Liabilities.
Also, a lot of theorizing about book value has come from the US market, where change of control is possible in almost any business. Part of the attraction of a company trading at a discount to book is that if the current management doesn’t improve performance, the company may be acquired, usually at a large premium to the prevailing stock price. I’m not sure that’s possible with MTNL.
Finally, I’m not familiar with the regulatory regime in India. You should ask yourself, however, whether MTNL is an independent concern, able to earn whatever profits it can, or whether it has a national service aspect to it, whereby its profit-making potential is limited for the greater good of the country as a whole.
Thanks for the reply.
For MTNL I am not double counting cash, what I was saying its available at ~ cash on the books. On Book Value basis its available at 50% discount to book (that of course includes cash).
This is a government company, but it has mandate for making profits, though the profits are declining. Yes, one thing can happen over here – another government company can takeover MTNL, but its very unlikely that the private player will acquire this company due to regulations.
Once again thanks for the reply.