Forbes India – Putting book value and price-earnings into perspective
For most investors, the key to successful investing lies in reducing the complexity of the task at hand to a few easily understood principles. A common approach is to value a company by applying a few well-established ratios such as the price-earnings (PE) ratio or the price-to-book (PB) ratio.
Benjamin Graham firmly believed that book value was a useful starting point for determining the intrinsic value of a business. Graham correctly assumed that stocks trading below book value could not continue to do so indefinitely. If the company was able to remain profitable on a sustainable basis, the stock price would eventually head north.
Still, the diligent investor should exercise caution when using book value to determine intrinsic value.
The first adjustment required is the need to value “intangible” assets or goodwill. When a company acquires a business and chooses to pay a premium to the book value, the difference should be taken to the balance sheet as “goodwill”. Accounting rules require that this “asset” be amortized over a specified period of time. The difficulty lies in determining whether “goodwill” has winning power or reflects the managerial ego driven by the desire to preside over a larger empire! Graham was unequivocal in arguing that goodwill should be deducted from book value, consistent with the view that it contradicts a margin of safety. More often than not, the hubris that accompanies an acquisition justifies being cautious in evaluating goodwill. Yet the argument of universally ignoring the residual value of goodwill is clearly wrong. When an acquisition results in the purchase of a strong franchise, proprietary technology or near-monopoly business, the higher purchase price generally reflects the capitalized value of future “excess returns”. Therefore, understanding the context of a business is essential to assess the value of intangible assets.
The need for the second adjustment arises from the accounting principle of valuing assets at historical cost or management’s perception of fair market value. The first rule in calculating liquidation value as Graham explained in Security Analysis is to assume that all liabilities are real but all assets have “doubtful value”. While cash equivalents and marketable securities are no problem, valuing assets such as inventory, receivables, and plant and equipment might be a little trickier.
Receivables, amounts due for goods sold on credit, should be valued at a slight discount to the value declared on the balance sheet, primarily because of the risk of non-payment and the time that may elapse before all dues are collected. As a general rule, the longer a company takes to collect its debts, the greater the discount to be applied.
The main inventory risk is obsolescence/perishability and market price fluctuations. While fixed assets are adjusted by a “depreciation” rate, the real issue is the “economic” life versus the “accounting” life of the assets. This difference can be reduced in either direction and often the difference can be significant. A gas transmission and distribution utility has a network of pipelines that directly defines its economic earning power. In this case, the economic life of the assets is much longer than that dictated by accounting requirements and therefore an established franchise in a specified geographic area has significant hidden value. Similarly, if a fully depreciated plant is well maintained and reasonably efficient, the asset will be significantly undervalued in value due to high inflation.
Book value can be misleading in a number of industries, including branded consumer staples, pharmaceuticals, and knowledge-based service franchises. This explains investors’ tolerance for extremely aggressive PB ratios in the valuation of these industries. Conversely, reported book value may be unfairly low for asset-rich real estate developers, especially in a high inflation environment.
Essentially, book value has limited use in judging upside, but is very relevant in determining the minimum level at which a stock might fall. Overall, provided there is demonstrable evidence of predictable earnings, it is eminently sensible to buy stocks trading close to their book value.
The PE ratio is by far the most common criterion used to evaluate a company. In effect, this number tells you how many years it will take to recoup your current investment assuming earnings remain constant. Therefore, the PE multiple reflects a consensus judgment on:
- Revenue growth prospects
- Expectations related to future profitability, and views in conjunction with the previous point, resultant increases in earnings per share
- Evolution of revenue growth rate and earnings per share
- The state of the business cycle and the need to normalize current earnings accordingly
Much like book value, PE multiples should be put into perspective against what the index is trading at, comparable numbers for the peer group within the industry, and a long-term historical trading range. In addition, it is essential to appreciate that the results represented in the denominator are not affected by exceptional or non-recurring items and are based on prudent accounting standards.
Another commonly used ratio is the price-to-sales (PS) multiple. This metric is most commonly associated with small cap growth companies. However, the PS is practically redundant in absolute terms since the underlying assumption is that sales are growing and profitable. The only rational way to benefit from PS ratios is to evaluate them in conjunction with operating profit margins. Intuitively, companies with higher margins should trade at a higher multiple. This makes the investment sound, as higher margins generally translate into higher revenue, which in turn leads to a faster return on investment. Experience suggests that using these ratios, the really smart decision may be to pay a slightly higher multiple to own a business with disproportionately greater earning power.
Based on these thoughts, one company worth serious consideration is FAG Bearings (Rs 1,365). Despite major headwinds in 2012, the company achieved 11% revenue growth and achieved EPS of Rs 95. In other words, that translates to a return on equity of 19% in its toughest year of the past decade.
Another way to understand the company’s exceptional earning power is to look at the 10-year averages for the period 2003-2012: 35.7% ROCE, 25.8% ROE and 27.3% annual growth made up of after-tax profits! An improving macroeconomic outlook, especially lower interest rates, should be a major positive for future growth. The disproportionate earning power in a monotonous business combined with the enormous safety margin (PE 14, PB 2.6 and PS 1.6) make FAG Bearings a convincing long-term investment.
Disclosure: This column does not constitute an offer to sell or a solicitation to buy any of the securities mentioned herein. The author frequently invests in the stocks he talks about.
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(This story appears in the May 17, 2013 issue of Forbes India. To visit our archives, click here.)