The Oracle of Omaha on why cash flows are more important than book value
March 03, 2020
For decades, value investors have used book value per share as a tool to assess a stock's value potential.
This approach began with Benjamin Graham. Widely considered to be the father of value investing, Graham taught his students that any stocks trading below book value were attractive investments because the companies offered a wide margin of safety and low level of risk. To this day, many value investors rely on book value as a shortcut for calculating value.
Buffett on book value
Warren Buffett (Trades, Portfolio) is perhaps Graham's best-known student. For years, Buffett used book value, among other measures, to asses a business's net worth. He also used book value growth as a yardstick for calculating Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) value creation.
However, as far back as 2000, the Oracle of Omaha started to move away from book value. He explained why at the 2000 annual meeting of Berkshire shareholders. Responding to a shareholder who asked him for his thoughts on using book value to track changes in intrinsic value, Buffett replied:
"The very best businesses, the really wonderful businesses, require no book value. They — and we are — we want to buy businesses, really, that will deliver more and more cash and not need to retain cash, which is what builds up book value over time...
In our case, when we started with Berkshire, intrinsic value was below book value. Our company was not worth book value in early 1965. You could not have sold the assets for that price that they were carried on the books, you could not have — no one could make a calculation, in terms of future cash flows that would indicate that those assets were worth their carrying value. Now it is true that our businesses are worth a great deal more than book value. And that's occurred gradually over time. So obviously, there are a number of years when our intrinsic value grew greater than our book value to get where we are today...
Whether it's The Washington Post or Coca-Cola or Gillette. It's a factor we ignore. We do look at what a company is able to earn on invested assets and what it can earn on incremental invested assets. But the book value, we do not give a thought to."
It is no secret that value as an investing style has underperformed growth over the past decade. There's no obvious explanation as to why this is the case, but one of the explanations could be that the definition of value is out of date. Buffett's comments from the 2000 annual meeting seem to support this conclusion.
No longer a good measure
Book value was an excellent proxy for value when companies relied on large asset bases to produce profits. As the economy has shifted away from asset-intensive businesses and more towards knowledge-intensive companies, book value has become less and less relevant.
What's more, as Buffett explained in 2000, book value does not necessarily represent intrinsic value. Just because a stock is trading below its book value does not necessarily mean it is worth said book value.
The same is true of companies trading at a premium to book. The intrinsic value of that business could be significantly higher than book value as book value does not tend to reflect intangible assets.
Investing is an art, not a science, and valuing businesses is not a straightforward process. Investors cannot rely on a simple metric or shortcut to assess value. Many factors contribute to intrinsic value and intrinsic value growth, and using book value as a proxy for intrinsic value is an outdated method. Even in Graham's time, it wasn't always correct.
https://www.gurufocus.com/news/1063604/warren-buffett-explains-why-book-value-is-no-longer-relevant
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