Saturday, 25 April 2009

Book Value: Theory Vs. Reality

Book Value: Theory Vs. Reality
by Andrew Beattie (Contact Author Biography)

Earnings, debt and assets are the building blocks of any public company's financial statements. For the purpose of disclosure, companies break these three elements into more refined figures for investors to examine. Investors can calculate valuation ratios from these to make it easier to compare companies. Among these, the book value and the price-to-book ratio (P/B ratio) are staples for value investors. But does book value deserve all the fanfare? Read on to find out.

What Is Book Value?

Book value is a measure of all of a company's assets: stocks, bonds, inventory, manufacturing equipment, real estate, etc. In theory, book value should include everything down to the pencils and staples used by employees, but for simplicity's sake companies generally only include large assets that are easily quantified. (For more information, check out Value By The Book.)

Companies with lots of machinery, like railroads, or lots of financial instruments, like banks, tend to have large book values. In contrast, video game companies, fashion designers or trading firms may have little or no book value because they are only as good as the people who work there.

Book value is not very useful in the latter case, but for companies with solid assets it's often the No.1 figure for investors.

A simple calculation dividing the company's current stock price by its stated book value per share gives you the P/B ratio. If a P/B ratio is less than one, the shares are selling for less than the value of the company's assets assets. This means that, in the worst-case scenario of bankruptcy, the company's assets will be sold off and the investor will still make a profit. Failing bankruptcy, other investors would ideally see that the book value was worth more than the stock and also buy in, pushing the price up to match the book value. That said, this approach has many flaws that can trap a careless investor.

Value Play or Value Trap?

If it's obvious that a company is trading for less than its book value, you have to ask yourself why other investors haven't noticed and pushed the price back to book value or even higher. The P/B ratio is an easy calculation, and it's published in stock summaries on any major stock research website. The answer could be that the market is unfairly battering the company, but it's equally probable that the stated book value does not represent the real value of the assets. Companies account for their assets in different ways in different industries, and sometimes even within the same industry. This muddles book value, creating as many value traps as value opportunities. (Find out how to avoid getting sucked in by a deceiving bargain stock in Value Traps: Bargain Hunters Beware!)

Deceptive Depreciation

You need to know how aggressively a company has been depreciating its assets. This involves going back through several years of financial statements. If quality assets have been depreciated faster than the drop in their true market value, you've found a hidden value that may help hold up the stock price in the future. If assets are being depreciated slower than the drop in market value, then the book value will be above the true value, creating a value trap for investors who only glance at the P/B ratio. (Appreciate the different methods used to describe how book value is "used up"; read Valuing Depreciation With Straight-Line Or Double-Declining Methods.)

Manufacturing companies offer a good example of how depreciation can affect book value. These companies have to pay huge amounts of money for their equipment, but the resale value for equipment usually goes down faster than a company is required to depreciate it under accounting rules. As the equipment becomes outdated, it moves closer to being worthless. With book value, it doesn't matter what companies paid for the equipment - it matters what they can sell it for. If the book value is based largely on equipment rather than something that doesn't rapidly depreciate (oil, land, etc), it's vital that you look beyond the ratio and into the components. Even when the assets are financial in nature and not prone to depreciation manipulation, the mark-to-market (MTM) rules can lead to overstated book values in bull markets and understated values in bear markets. (Read more about this accounting rule in Mark-To-Market Mayhem.)

Loans, Liens and Lies

An investor looking to make a book value play has to be aware of any claims on the assets, especially if the company is a bankruptcy candidate. Usually, links between assets and debts are clear, but this information can sometimes be played down or hidden in the footnotes. Like a person securing a car loan using his house as collateral, a company might use valuable assets to secure loans when it is struggling financially. In this case, the value of the assets should be reduced by the size of any secured loans tied to them. This is especially important in bankruptcy candidates because the book value may be the only thing going for the company, so you can't expect strong earnings to bail out the stock price when the book value turns out to be inflated. (Footnotes to the financial statements contain very important information, but reading them takes skill. Check out An Investor's Checklist To Financial Footnotes for more insight.)

Huge, Old and Ugly

Critics of book value are quick to point out that finding genuine book value plays has become difficult in the heavily analyzed U.S. stock market. Oddly enough, this has been a constant refrain heard since the 1950s, yet value investors still continue to find book value plays. The companies that have hidden values share some characteristics:

  • They are old. Old companies have usually had enough time for assets like real estate to appreciate substantially.
  • They are big. Big companies with international operations, and thus with international assets, can create book value through growth in overseas land prices or other foreign assets.
  • They are ugly. A third class of book value buys are the ugly companies that do something dirty or boring. The value of wood, gravel and oil go up with inflation, but many investors overlook these asset plays because the companies don't have the dazzle and flash of growth stocks.

Cashing In

Even if you've found a company that has true hidden value without any claims on it, you have to wait for the market to come to the same conclusion before you can sell for a profit. Corporate raiders or activist shareholders with large holdings can speed up the process, but an investor can't always depend on inside help. For this reason, buying purely on book value can actually result in a loss - even when you're right. If a company is selling 15% below book value, but it takes several years for the price to catch up, then you might have been better off with a 5% bond. The lower-risk bond would have similar results over the same period of time. Ideally, the price difference will be noticed much more quickly, but there is too much uncertainty in guessing the time it will take the market to realize a book value mistake, and that has to be factored in as a risk. (Learn more in Could Your Company Be A Target For Activist Investors? Or read about activist shareholder Carl Icahn in Can You Invest Like Carl Icahn?)

The Good News

Book value shopping is no easier than other types of investing, it just involves a different type of research. The best strategy is to make book value one part of what you look for. You shouldn't judge a book by its cover and you shouldn't judge a company by the cover it puts on its book value. In theory, a low price-to-book-value ratio means you have a cushion against poor performance. In practice it is much less certain. Outdated equipment may still add to book value, whereas appreciation in property may not be included. If you are going to invest based on book value, you have to find out the real state of those assets.

That said, looking deeper into book value will give you a better understanding of the company. In some cases, a company will use excess earnings to update equipment rather than pay out dividends or expand operations. While this dip in earnings may drop the value of the company in the short term, it creates long-term book value because the company's equipment is worth more and the costs have already been discounted. On the other hand, if a company with outdated equipment has consistently put off repairs, those repairs will eat into profits at some future date. This tells you something about book value as well as the character of the company and its management. You won't get this information from the P/B ratio, but it is one of the main benefits from digging into book value numbers, and is well worth the time. (For more information, check out Investment Valuation Ratios: Price/Book Value Ratio.)

by Andrew Beattie, (Contact Author Biography)

Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.

Also read: Nets and net net

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