Carrying value is insufficient as a means of measuring value


In our recent article on Return on Equity Defects, we showed that it has no correlation with several different valuation metrics. However, there is one valuation measure, the price per book (“P / B”), which at first glance appears to be strongly correlated with ROE. A closer examination reveals that the relationship between the two variables is not as strong as it seems at first glance.

Major outliers can distort correlations disproportionately, and this is what happens with a quick assessment of ROE versus P / B correlations. Removing companies (only 3 in this case) that each had an impact of at least 5% on the r-squared value, as well as companies that had negative book values, reveals a weak correlation of 27%. See figure 1.

Figure 1: the correlation is not really significant

When you don’t remove any of the major outliers, the correlations are biased, ROE and P / B may have an extremely high correlation. Figure 2 shows an r-squared value of 98%.

Figure 2: Apparently high correlation between ROE and P / B

As shown in Figure 1, variations in ROE actually explain only 27% of the P / N difference between different companies. None of these metrics is a consistently useful valuation indicator. Both are subject to significant deviations from the underlying economic reality, as they both rely on the same imperfect accounting rules.

Book value can be misleading

Book value suffers from some major flaws when it comes to measuring valuation

  1. This carrying amount may be impaired at the discretion of management at any time.
  2. Companies can hide both assets and liabilities on the balance sheet so that they are not reflected in the book value.
  3. Accounting rules are designed to give the best estimate of liquidation value for debt investors, not to measure the capital used to generate returns, which is important for equity investors.

Since equity and book value are the same thing, ROE and P / B are based on the same accounting concept, which makes them both equally unnecessary for equity investors.

The threat of write-downs

Mergers and acquisitions are some of the most common sources of artificial book value. We warned investors of this fact in July with our article on goodwill. When a company buys another company at a premium over its net asset value, the excess purchase price is recorded as goodwill. Goodwill is recorded as part of the carrying amount, but often ends up being impaired if the acquisition is less than expected.

Impairments end up being very common. 53% of all acquisitions end up destroying value, and we’ve found tens of thousands of write-downs totaling over $ 1 trillion in records we’ve analyzed since 1998.

Figure 3: Book value disappears during times of risk

They end up happening most often in stock market crashes, as shown in Figure 2. This means that investors who, although they were in cheap stocks because of the P / B ratio, have a nasty surprise when billions of dollars are wiped off the balance sheet.

Hidden assets and liabilities

We make several adjustments to move from reported net assets to invested capital, as companies can hide assets and liabilities on the balance sheet in the form of reserves, operating leases, deferred compensation, and many other techniques.

These off-balance sheet arrangements meant that the shareholder’s equity line ignored a significant portion of the resources a company uses in its operations.

The liquidation value has limited value for equity investors

Book book value is meant to measure the potential assets available to investors in the event of a liquidation, and it’s just not a very useful metric for most equity investors. If the business you invest in is wound up, it is almost always a failed investment.

Even the idea that a low price for booking limits your downside potential is wrong. Impairments or hidden liabilities can send the stock price below book value, just like a business that earns a negative return on invested capital (ROIC).

The accounting rules were designed for use by debt investors. Equity investors should not expect the financial statements generated by these rules to contain numbers that accurately reflect their concerns.

Measure economic book value

Instead of focusing on book value, investors should look for companies that are priced low to economic book value (PEBV). Rather than relying on accounting rules, the economic book value comes from the operating result after tax (NOPAT) and the weighted average cost of capital (WACC). Instead of measuring a company’s liquidation value, it measures its zero growth value, which is a better benchmark for equity investors.

Rather than looking at the erroneous measures of ROE and P / B, we have found that ROIC and PEBV tend to be better indicators of future performance. Here are recent examples of this phenomenon:

  • Nvidia (NVDA), our long idea from September 24th. From a ROE and P / B perspective, NVDA seemed to be in the middle of the pack in the semiconductor industry. Our research has shown that it is in fact one of the most profitable and cheapest companies in the industry, with a ROIC of over 30% and a PEBV of just 1.1, which implies growth of NOPAT of only 10% for the rest of its business life. In the past two and a half months NVDA has grown by 37%
  • El Pollo Loco (LOCO), our selection of danger zones from March. Non-operating items inflated GAAP net income and off-balance sheet debt masked the actual amount of capital used in the company’s operations. This allowed LOCO to achieve a ROE of 20%, well above its actual ROIC of just 6%. And while his P / B of 4.8 didn’t look cheap, it was still better than his PEBV of 5.2. LOCO has collapsed in recent months and is now down more than 50% since our call.

Reviewing the ROIC and PEBV helps you identify winners and losers, as these metrics remove the noise and artificial accounting constructs that are at the heart of valuation methodologies used by many investors.

Disclosure: David Trainer and Sam McBride receive no compensation for writing about a specific stock, industry, style, or topic.


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