What book value means for investors
Profits, debt and assets are the building blocks of the financial statements of any public enterprise. For disclosure purposes, companies break down these three into more specific numbers for investors to look at. Investors can calculate valuation ratios from these to make it easier to compare companies. Among these, book value and price to book ratio (P / E ratio) are must-haves for value investors. But does book value deserve all the fanfare? Keep reading to find out.
Key points to remember
- The book value of a business is the difference in value between the total assets and the total liabilities of that business on its balance sheet.
- Value investors use the price-to-book (P / B) ratio to compare a company’s market capitalization to its book value to identify potentially overvalued and undervalued stocks.
- Traditionally, a P / B of less than 1.0 is considered a good value, but it can be difficult to identify a “good” P / N ratio as it can vary by industry and any particular business may have issues. underlying financial instruments.
What is book value?
Book value is the measure of all of a company’s assets: stocks, bonds, inventory, manufacturing equipment, real estate, etc. In theory, book value should include everything down to pencils and staples used by employees, but for the sake of simplicity, companies typically only include large assets that are easily quantifiable.
Companies with many machines, such as railways, or many financial instruments, such as banks, tend to have high book values. In contrast, video game companies, fashion designers, or trading companies may have little or no book value because they are as good as the people who work there. Book value isn’t very useful in the latter case, but for companies with solid assets, it’s often the # 1 number for investors.
A simple calculation dividing the current price of the company’s stock by its reported book value per share gives you the P / B ratio. If a P / B ratio is less than one, the shares sell for less than the value of the company’s assets. This means that in the worst case scenario of bankruptcy, the assets of the business will be sold and the investor will still make a profit.
A price-to-book ratio below 1.0 usually indicates an undervalued stock, although some value investors may set different thresholds, such as below 3.0.
In the event of bankruptcy, other investors would ideally see that the book value was worth more than the stock and would also buy, pushing the price up to match the book value. That said, there are many flaws in this approach that can trap a reckless investor.
Value Play or Value Trap?
If it’s obvious that a company is trading below its book value, you must be wondering why other investors haven’t noticed and lowered the price to book value or even higher. The P / N ratio is an easy calculation, and it’s posted in the stock summaries of any major stock research website.
The answer could be that the market is unfairly hitting the business, but it is just as likely that the reported book value does not represent the true value of the assets. Companies account for their assets in different ways in different industries, and sometimes even within the same industry. This confuses book value, creating as many value traps as there are value opportunities.
Misleading amortization and book value
You need to know how aggressively a company has depreciated its assets. This involves going back over several years of financial statements. If quality assets have depreciated faster than the decline in their true market value, you have found hidden value that can help hold the stock price in the future. If assets depreciate more slowly than the decline in market value, then the book value will be higher than the true value, creating a value trap for investors who only look at the P / N ratio.
Manufacturing companies are a good example of how depreciation can affect book value. These companies have to pay huge sums of money for their equipment, but the resale value of the equipment generally decreases faster than a company is required to depreciate it under accounting rules. As the equipment becomes obsolete, it gets closer to worthless value.
With book value, it doesn’t matter what the companies paid for the equipment. It doesn’t matter what they can sell it for. If book value relies heavily on equipment, rather than something that doesn’t depreciate quickly (oil, land, etc.), it’s critical that you look beyond the ratio and into the components. Even when assets are financial in nature and not subject to depreciation manipulations, mark-to-market (DMM) rules can result in overestimated book values ââin bull markets and underestimated values ââin markets. bear markets.
Loans, liens and lies in book value
An investor seeking to stake book value should be aware of any claims on the assets, especially if the company is a bankruptcy candidate. Usually the links between assets and debts are clear, but sometimes this information can be understated or hidden in footnotes. Like a person who obtains a car loan using their home as collateral, a business can use valuable assets to secure loans when it is in financial difficulty.
In this case, the value of the assets should be reduced by the size of the secured loans linked to them. This is especially important for bankruptcy applicants, as book value may be the only thing that goes to the business, so you can’t expect solid earnings to bail out the stock price when the value accountant turns out inflated.
Companies adapted to book value games
Critics of book value are quick to point out that it has become difficult to find genuine coins of book value in the heavily analyzed US stock market. Oddly enough, this has been a constant refrain since the 1950s, but value investors continue to find book value games.
Companies with hidden values ââshare certain characteristics:
- They are old. Older businesses have generally had enough time for assets such as real estate to appreciate significantly.
- They are tall. Large companies with international operations, and therefore international assets, can create book value through the growth in prices of land abroad or other foreign assets.
- They are ugly. The third category of book value purchases are ugly businesses doing something dirty or boring. The value of lumber, gravel, and oil rises with inflation, but many investors overlook these assets because companies lack the luster and luster of growth stocks.
Cash in book value
Even if you have found a business that has real hidden value without any claims, you have to wait for the market to come to the same conclusion before you can sell at a profit. Corporate raiders or activist shareholders with large holdings can speed up the process, but an investor can’t always count on internal help. For this reason, buying only at book value can actually result in a loss, even when you are right!
If a business sells 15% below book value, but it takes several years for the price to catch up, you might have been better off with a 5% bond. The lower risk bond would have similar results over the same period.
Ideally, the price difference will be noticed much faster, but there is too much uncertainty to guess how long it will take the market to realize a book value error, and this should be taken into account as a risk.
That said, a closer look at book value will give you a better understanding of the business. In some cases, a business will use excess profits to update equipment rather than paying dividends or expanding its business. While this drop in profits may lower the value of the business in the short term, it creates long term book value because the business equipment is worth more and the costs have already been discounted.
On the other hand, if a business with outdated equipment has consistently postponed repairs, those repairs will reduce profits at a future date. This tells you about the book value as well as the character of the business and its management. You won’t get this information from the P / N ratio, but it’s one of the main benefits of digging into the book value numbers and it’s worth it.
The bottom line
Buying book value is no easier than other types of investing; it’s just another kind of research. The best strategy is to make book value part of what you are looking for. You shouldn’t judge a book by its cover, and you shouldn’t judge a business by the cover it puts on its book value.
In theory, a low price-to-book ratio means you have some protection against poor performance. In practice, it is much less certain. Obsolete equipment may still add to the book value, while property appreciation may not be included. If you plan to invest on a book value basis, you need to know the actual condition of those assets.