plusses and minuses of using book value

on the plus side…

–book value is a simple, easy to understand, concept.  Discount to book = cheap, premium to book = a potential red flag.

–it’s very useful for financials, which tend to have huge numbers of often complex, short-lived transactions with hordes of different customers, and where financial disclosure may not be so transparent (financials aren’t my favorite sector, by the way).  So the 30,000 foot view may be the best.

…maybe a plus?…

–in the inflationary world most of us grew up in, and that is still reflected in the financials of older companies, historical cost accounting tends to understate the current value of long-lived assets.  Think:  a piece of land bought in Manhattan or San Francisco in 1950 or an oilfield discovered in 1970–or 1925.  Many of the older retail chain acquisitions of the past twenty years have been motivated by the undervaluation on the balance sheet of owned real estate.

…definitely a minus

–in my experience, accountants tend to be very reluctant to compel managements to write down the value of assets whose worth has been impaired by, say, advanced age or technological obsolescence.

–more important, we are living in a period of rapid change.  The Internet is the most obvious new variable, although I think we tend to underestimate how profound its transformative power is.  In the US, we are also seeing a generational shift in economic power away from Baby Boomers and toward Millennials, who have distinctly non-Boomer preferences and a desire to live a different lifestyle from their parents.

Online shopping undermines the value of an extended physical store network.  Software (which by and large doesn’t appear on the balance sheet) replaces hardware (which does) as a key competitive edge between companies.

intangibles…

Warren Buffett’s key innovation as an investor was to recognize the value of intangibles like this in the 1950s.  In his case, it was that the positive effect of advertising expense and strong sales networks in establishing brand power appeared nowhere on the balance sheet.  In a world where his competitors were focused only on price-to-book, he could buy these very positive company attributes for free.  Price to book was still a solid tool, just not the whole picture.

…vs. structural change

The situation is different today.

The Internet is eroding the value of traditional distribution networks and of other physical assets positioned to serve yesterday’s world.  The shift in economic power to Millennials is likewise calling into question the value of physical assets positioned to serve Boomers.

In more concrete terms:

Tesla doesn’t need a car dealer distribution network to sell its cars.  A retailer can use Amazon, or Etsy or a proprietary website, rather than an owned store network.  A writer can self-publish.  These all represent radical declines in the capital needed to be in many businesses today.

Millennials like organic food and live in cities; Boomers eat processed food and live in the suburbs.

This all calls into question the present economic worth, still expressed on the balance sheet as book value, of past capital spending on what were at the time anti-competition “moats.”

Another issue:   I think that the institutional weight of the status quo has pressured managements of older companies into ignoring the need for substantial repositioning–including writedowns of no-longer viable assets–so they can compete in a 21st century environment.  Arguably, this makes low price to book a warning sign instead of an invitation to purchase.

using book value as an analytic tool

historical cost

Generally speaking, all of a company’s balance sheet data are recorded at historical cost (adjustments for currency fluctuations for multinational firms are he only exception I can think of this early in the morning).

book value

If this accurately reflect’s today’s values, and sometimes this can be an IFthen

…book value is an accurate indicator of the market value of shareholders’ ownership interest in the firm.

asset value

That means that price/book (share price divided by book (shareholders equity) value per share) can be an indicator of over/undervaluation.  In particular, if a company’s shares are trading below book, then it could potentially be broken up and sold at a profit.

management skill

We can also use return on book value (yearly net profit divided by book value) as a way of assessing management’s skill in using the assets it controls to make money.  This can be a particularly useful shorthand in the case of, say, financial firms, which tend to have fingers in a lot of pies and to disclose little about many of them.

Notes:

–price/book is not a linear or symmetrical measure.

On the one hand, a basic tenet of value investing is that when the return on book is unusually low either the company’s board or third parties will force change.  So weak companies may trade at smaller discounts to book than one might think they deserve.

On the other, strong performing firms will likely trade at premiums to book.  However, the amount of the premium will depend both on the state of “animal spirits” and more sober judgments about the sustainability of above-average results.

return on book vs. return on capital.  Return on capital is the same kind of ratio as return on book and has the same intent–to assess how well management is using the assets it is entrusted with.  The difference is that ROC factors in any long-term debt a company may have.

Return on capital is defined as:  (net profit + after-tax interest expense) divided by (long-term debt + shareholders equity).

Return on capital and return on book value are the same if a company has no long-term debt.  Return on capital is typically lower than return on book if a company has long-term borrowings, debt capital usually costs (a lot) less than equity capital.

using return on capital

ROC and the spread between ROC and ROB can be important.  We should think of ROC as the profitability of the business enterprise and the difference between it and ROB as the return on financial leverage.

For instance, for a given firm, the ROC may be 10% and the return on book (equity) 15%.  The difference, 5 percentage points, is the result of “financial engineering,” or the leveraged structure of the company.  Those figures may be ok (and, for the record, I’m not against leverage per se).  But if the ROC is 2% and the ROB is 12%, virtually all the profits of the firm come from financial leverage–not from the underlying business.  That’s a risky situation, in my view–one that owners should be aware of.

More tomorrow.

 

 

 

 

 

price to book: a traditional, but flawed, tool

what book value is

It’s another term for shareholders equity, the financial accounting tally of the total amount of money shareholders, as owners have provided management to work with–through purchases of stock from the company and through profits retained in the business.  It’s called “book” value because the figure is taken from the company’s accounting books.

An example:

We form Ace Investment Advice (AIA) by selling 100,000 new shares to backers at $10 each.

Our balance sheet is simple.  We have cash of $1 million on the asset side, no liabilities and net worth (aka shareholders equity or book value) of $1 million, or $10 a share.

Let’s say AIA earns $200,000 in its first year of operation and distributes nothing to shareholders.  At the end of the year, net worth/book value is $1.2 million, or $12 a share.

how it’s used

return on equity and management skill

AIA management took $1 million and earned $200,000 with it during the year.  That’s a return of 20%  (yes, if management earned that money in a linear fashion through the year, the number is slightly lower, but let’s not worry about that refinement here).

I can compare this performance to what the management of similar firms has accomplished to see whether that’s good or bad.

price to book

I can also compare this performance with that of the managements of all other publicly traded companies, to see if this is a stock I should want to own.

If management is regularly able to achieve a 20% return on the shareholder funds, I probably do want to be a shareholder.  And I’m likely to be willing to pay a premium to book value–let’s say 1.5x book, or even 2.0x book– to become one.

On the other hand, if AIA consistently earns a 2% return on shareholder funds, then the stock doesn’t look attractive to me at all, at least not at book value.  Maybe I only want to pay 50% of book value for it.  And even then I’m probably betting that the board of directors will find better management to run the firm or that an acquirer will be attracted by the discount to book value and make a bid to take it over.

More on Monday.