The beauty of book value

This article is the fifth in a series of introductory value-based investing that was first published in 2006 and has become the heart of our book Value: The Intelligent Investor’s Guide to find hidden gems on sharemarket.
See also: 1. The essence of value investing; 2. What price is a safety margin ?; 3. How to evaluate the actions; 4. Value-Driven Investing, via Don Bradman; 6. Put a price on profits; 7. The delights of dividends.

In How to Evaluate Equities, the third part of this series on Smart investor the approach of equity teams to stock selection, we have seen that equities are worth the present value of the future cash they generate. We can either consider this cash in terms of dividends paid or in terms of net cash produced by the company.

Despite a few shortcomings (which we will come back to shortly), this theory provides a framework for comparing different companies no matter what they do with their cash flow. But if you give an analyst a theoretical framework, he’ll give you a 15-page spreadsheet.

After all, if a business is worth the present value of its future cash flows, then why not put together a giant sum, calculate all of those cash flows, discount them to their present value, and add them up? Called “discounted cash flow” calculations, they are all the rage these days, but, oddly, not so much before the advent of the computer.

Crazy numbers

In practice, such assessments are not worth the space they occupy on your hard drive. First, you can get so wrapped up in the math that it’s easy to forget the numbers you enter. Second, when you combine estimates, the results become so rough that they are of little use. Finally, there is a temptation to give the end result too much credibility due to all the effort incorporated into your elegant spreadsheet.

Your best bet is to stick to a few simple valuation tools, such as price-to-book, dividend yield and PER, and then allow for a large margin of safety. But it is essential to see these tools only in the context of helping you reach an estimate of the present value of a company’s future cash flows.

The simplest tool of all is the price-to-book ratio, which is a company’s market capitalization divided by its net asset value (or “book value”). Book value represents what the company paid for all of its assets and what it would receive if it sold them all and returned the proceeds to shareholders.

Accounting confusion

The beauty of book value is its simplicity, although it does come with a few issues. First, book value is not the value of a company’s assets but what it paid for them, minus an arbitrary charge for usury and more or less accounting confusion.

You must therefore pay attention to the assets to be included in your book value and the values ​​assigned to them. Facilities and machinery dedicated to a declining industry could have a much lower value than what is actually shown in the balance sheet. Other assets, like cash, have a more defined value. In between are things like inventory and accounts receivable, the value of which will depend on how confident you are that they can be successfully converted to cash.

Some assets, such as property, may be understated, and some valuable “intangible” assets, such as brands, goodwill, and intellectual property, may not even show up at all. The Coca-Cola Company (NYSE: KO) had a book value of US $ 25 billion in April, but according to Interbrand its main brand is worth US $ 78 billion. Even that can be small if you look at the company’s US $ 200 billion market capitalization.

So everything is a bit circular. All roads ultimately lead to the fundamental truism that a piece of capital is worth what it can earn.

Not all capital is created equal

Which brings us to our second problem, which is that not all companies give the same returns. Some companies consistently achieve well above average returns, either because of competitive advantages or good management, or both. Economic theory says that these factors need to be corrected over time, but in practice they can persist for centuries.

All other things being equal, a good company achieving high returns on capital will justify a higher price-to-book ratio than a bad company achieving low returns.

So the advantage of the price of booking is that it’s quick and easy; the downside is that it often doesn’t tell you much about the value of a business. That said, it can provide some useful pointers.

IMPORTANT: Intelligent Investor is published by InvestSMART Financial Services Pty Limited AFSL 226435 (Licensee). Information is general advice on financial products. You should consider your personal goals, financial situation and needs before making any investment decisions and reviewing the product disclosure statement. InvestSMART Funds Management Limited (D) is the entity responsible for various managed investment programs and is a related party of the Licensee. The SO may own, buy or sell the stocks suggested in this article simultaneously or after the publication of this article. Any such transaction could affect the share price. All indications of performance returns are historical and cannot be taken as an indicator of future performance.

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