Book Value (II)–where it doesn’t work so well

As I mentioned in my prior post on book value, using it as a valuation tool works best when the company in question has plain-vanilla assets, and where assembling capital to be able to purchase productive assets–whose worth is accurately shown on the balance sheet–is a key part of its ability to compete.

It stands to reason, then, that problems will arise when this condition isn’t met.

Examples:

Companies with powerful brand names or distribution networks. This was Warren Buffett’s essential insight a half-century ago.  If  for twenty years a company spends 3% of sales each year on advertising a given product, it will in all likelihood have established customer awareness of its brand.  The brand may not be Tide or Cheerios or Lexus (although it may be), still the brand probably has a considerable value.  But not only doesn’t that expense not show up anywhere on the balance sheet, it has reduced profits, and therefore the shareholders’ equity account, for all that time.  Takeover bids for companies with brand names almost always come at a sizable premium to book for this reason.

One of the great retailing stories of the last fifty years has been the demise of the department store, department by department, by specialty retailers, who distributed in highly focused, single-purpose stores in suburban locations.  Toys R US, Limited and Bed, Bath & Beyond are only a few examples.

Almost no one has heard of Child World or Lionel’s Kiddie City. That’s because they lost the race to establish the first national toy store chain to Toys R Us.  But even as TOY crossed the finish line first, dooming the others, their books values weren’t that dissimilar.

In today’s world, one might argue that the difference between Barnes and Noble and Borders is the former’s superior internet distribution.  Amazon beats them both for the same reason. Yet this difference is more one of management decision than balance sheet construction.  At .6x book value, it’s not clear to me that BGP is cheap.

2.  natural resources companies. This is really a specialist topic that I’ll eventually write more about.  This is the version done with crayons.

In the simplest terms, resource reserves are defined as what can be produced at a profit using today’s extraction technology.  As prices go up and as technology gets better the amount of economically recoverable oil, gas, gold, copper…a company has rises. But the company’s balance sheet list them only at the (depreciated) cost of finding the deposits.  That may have been fifty or even a hundred years ago.

As a result, the balance sheet metrics that apply to non-mining companies may have little relevance.  ExxonMobil, for example, carries its oil and gas reserves on its balance sheet at $67.6 billion but lists the present value of it reserves, calculated using the SEC method, at $86.0 billion.  In my estimation, this is an extremely conservative number.

Other mining companies typically only “prove up,” i.e., formally document and establish, reserves they may need to collateralize bank borrowing.  They may only be a small section of a huge orebody, but if the entire extent hasn’t been drilled to establish the mineral composition, the undrilled portion is technically not “reserves”– and therefore reported only as unexplored acreage.

3.  service companies. That is, companies that don’t manufacture goods, but provide services instead.  Software companies like Microsoft are a good example.  MSFT, which now trades at about $28 a share–in its heyday, it was as high as $60–has a book value of about $4 a share.  The price is 7x book.

But there’s nothing on its balance sheet for its brand name, or its domination of personal computer productivity software and operating systems.  It’s research and development expenditures are by and large expensed rather than put on the balance sheet.  So, like the case of advertising expense above, they reduce rather than add to book value.  Price/cash flow is probably a better measure here.

4.  companies that issue new stock. This could be to fund internal capital expansion or the purchase of a rival.  The stock issuance can change book value significantly.

Assume a company has 100 shares outstanding, book value of $10 a share and is trading at $20 a share.  If it issues 100 shares of new stock at $20 (yes, an issue this large is unlikely, but it illustrates the point), then it has book value of $1000 from the initial shares and book of $2000 from the new shares.  In other words, it’s new book value is $15.

5.  auditors’ practices in writing assets up or down. Most auditors, in my experience, are loathe to insist on writedown of impaired assets beyond the extent that company managements are content with.  Auditor practices vary, I think, as do management tolerances for writedowns.  As a result, so too do writedowns.  This is something to at least consider when doing company to company comparisons.

In addition, some countries–not the US–suggest/require that companies write their  assets up to fair market value periodically.  This sometimes makes book value comparison of companies domiciled in different countries, but with similar assets, problematic.

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