Conventional Valuation Yardsticks: Book Value

Book Value

What something cost in the past is not necessarily a good measure of its value today.  Book value is the historical accounting of shareholders' equity, the residual after liabilities are subtracted from assets.

Sometimes historical book value (carrying value) provides an accurate measure of current value, but often it is way off the mark.

• Current assets, such as receivables and inventories, for example, are usually worth close to carrying value, although certain types of inventory are subject to rapid obsolescence. 
• Plant and equipment, however, may be outmoded or obsolete and therefore worth considerably less than carrying value. 
• Alternatively, a company with fully depreciated plant and equipment or a history of write-offs may have carrying value considerably below real economic value. 
• Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. 
• Real estate purchased decades ago, for example, and carried on a company's books at historical cost may be worth considerably more. 
• The cost of building a new oil refinery today may be made prohibitively expensive by environmental legislation, endowing older facilities with a scarcity value. 
• Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built mini-mills. As a result, their book value may be significantly overstated. 

Reported book value can also be affected by management actions.

• Write-offs of money-losing operations are somewhat arbitrary yet can have a large impact on reported book value. 
• Share issuance and repurchases can also affect book value. 
• Many companies in the 1980s, for example, performed recapitalizations, whereby money was borrowed and distributed to shareholders as an extraordinary dividend. This served to greatly reduce the book value of these companies, sometimes below zero. 
• Even the choice of accounting method for mergers-purchase or pooling of interests - can affect reported book value.

To be useful, an analytical tool must be consistent in its valuations. Yet, as a result of accounting rules and discretionary management actions, two companies with identical tangible assets and liabilities could have very different reported book values.

• This renders book value not terribly useful as a valuation yardstick. 

As with earnings, book value provides limited information to investors and should only be considered as one component of a more thorough and complete analysis.

Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Warren Buffett on Economic Goodwill (Intangible asset)

WARREN BUFFETT ON ECONOMIC GOODWILL

This is what Warren Buffett calls economic good will which he explained in 1983 like this:

‘[B]usinesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.’

Using by analogy, one of the favorite examples of Warren Buffett, take two separate companies. Company A has a net worth of $100,000, $40,000 of which is net tangible assets and $60,000 of which is intangible (brand name, goodwill, patents etc). Company B has the same net worth but $90,000 its assets are tangible. Each company earns $10,000 a year.

• So Company A is earning $10,000 from tangible assets of $40,000 and Company B is earning $10,000 from tangible assets of $90,000.

If both companies wanted to double earnings, they might have to double their investment in tangible assets. 

• For Company A to do this, it would have to spend $40,000 to add $10,000 of earnings. 
• For Company B to do this, it would have to spend another $90,000 to add $10,000 to earnings. 

All other things being equal, Company A would have better future prospects of increase in real earnings than Company B.

THE REAL PROFITABILITY OF A COMPANY

For these reasons, Warren Buffett has said that, in calculating the real profitability of a company, there should be no amortisation of economic goodwill. Does the Gillette brand name actually decrease in value each year? Of course not.

The thoughts of both Graham and Warren Buffett are worth consideration. Book value is another ingredient in the investment equation.

WHAT IS BOOK VALUE?

WHAT IS BOOK VALUE?

The book value of a company is generally considered its net worth; the book value per share would be the net worth of a company divided by the number of shares outstanding.

BENJAMIN GRAHAM DEFINITIONS

There is a need, in considering the book value of a company share, to know what certain terms mean - and who better to explain them than the doyen of investment analysis, Benjamin Graham. His definitions are:

Tangible assets: Assets either physical or financial in character eg plant, inventory, cash, receivables, investments.

Intangible assets: Assets which are neither physical nor financial in character. Include patents, trademarks, copyrights, franchises, good will, leaseholds and such deferred charges as unamortised bond discount.

Graham took the view in Security Analysis that intangible assets should not be taken into account when calculating book value; hence, in this sense, book value per share would be the same as net tangible assets per share (NTA) as opposed to net assets per share (NA).

So, the assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

Finance for Managers: Asset-Based Valuations - Adjusted Book Value

The weakness of the quick-and-dirty equity-book-value approach have led some to adopt adjusted book value, which attempts to restate the value of balance-sheet assets to realistic market levels.  Consider the influence of adjusted book value in a leveraged buyout of a major retail store chain in the 1990s.  At the time of the analysis, the store chain had an equity book value of $1.3 billion.  Once its inventory and property assets were adjusted to their appraised values, however, the enterprise's value leaped to $2.2 billion - an increase of 69 percent.

When adjusting asset values, it is particularly important to determine the real value of any listed intangibles, such as goodwill and patents.  In most cases, goodwill is an accounting fiction created when one company buys another at a premium to book value - that is, at a price higher than book value.  The premium must be put on the balance sheet as goodwill.  But to a potential buyer, the intangible asset may have no value.