Why book value can be misleading


– By Rupert Hargreaves

Book value is a fundamental part of value investing. The metric is important because it gives a fundamental value of a company. In theory, if a company were to declare bankruptcy, that would be what the assets would earn at auction.

Of course, in the real world, book value is relatively unreliable. Some assets are only worth something to the company that owns them, and it is not known how much an asset will be worth if it is auctioned. Even tangible assets, which are generally considered to be fully reliable, can end up worth less than their recorded value once all is said and done.

Another big problem with valuing a business based on book value is the fact that the average investor is very unlikely to ever benefit from the discount. For example, early in his career, Warren Buffett (Trades, Portfolio) was able to buy stocks trading at a steep discount to book value and then shake companies up to release value. Since most average investors buy less than 1% of businesses when they invest, there is simply no way to shake up a business to unleash value, and there is no real way to unleash value. value.

To put it another way, book value can be a misleading way to value a business, something Buffett has commented on several times in the past. Here are some of his comments on book value pitfalls:

“Of course, it’s the intrinsic value per share, not the book value, that matters. Book value is an accounting term that measures the capital, including retained earnings, that has been invested in a company. Embedded value is an estimate of the present value of money that can be taken out of a business during its remaining lifespan. In most businesses, the two values ​​are not related.

We define intrinsic value as the present value of cash that can be withdrawn from a business during its remaining life. Anyone calculating intrinsic value necessarily ends up with a highly subjective figure that will change both as estimates of future cash flows are revised and interest rates change. Despite its vagueness, however, intrinsic value is paramount and is the only logical way to assess the relative attractiveness of investments and businesses. “-1993 Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) letter

The difference between book value and intrinsic value is essential:

Book value the virtue as a scoring measure is that it is easy to calculate and does not involve the subjective (but important) judgments employed in calculating the intrinsic value of the business.

It is important to understand, however, that the two terms – book value and intrinsic business value – have very different meanings. Book value is an accounting concept, recording the accumulated financial contribution of both contributed capital and retained earnings. The intrinsic value of the business is an economic concept, estimating the future cash outflow discounted to present value. The book value tells you what has been put in place; the intrinsic value of the company estimates what can be withdrawn.

An analogy will suggest the difference. Suppose you spend identical amounts to get each of two children to go to college. The book value (measured by the financial contribution) of each child’s education would be the same. But the present value of the future gain (the intrinsic business value) can vary wildly – from zero to many times the cost of education. Likewise, companies with an equal financial contribution end up with large variations in value. “-Berkshire Letter 1983

And finally, why book value can be a misleading indicator of value:

“Some investors weigh book value strongly in their stock purchase decisions (as I did in my early years). And some economists and academics believe that replacement values ​​are of tremendous importance in calculating an appropriate price level for the stock market as a whole.

Those of the two convictions would have received an education during the auction which we organized at the beginning of 1986 to dispose of our textile machines. The equipment sold (including some divested in the few months leading up to the auction) occupied approximately 750,000 square feet of factory space in New Bedford and was fully serviceable. It originally cost us about $ 13 million, of which $ 2 million was spent from 1980 to 1984, and had a current book value of $ 866,000 (after accelerated depreciation). While no sane management would have made the investment, the equipment could have been replaced new for perhaps $ 30-50 million.

Gross proceeds from the sale of this equipment amounted to $ 163,122. Taking into account the necessary pre and post-sales costs, our net was less than zero. Relatively modern looms that we bought for $ 5,000 each in 1981 did not find a buyer for $ 50. We ended up scrapping them for $ 26 apiece, which is less than the moving costs.

Think about this: The economic goodwill attributable to two paper routes in Buffalo – or a single See’s candy store – greatly exceeds the proceeds we received from this massive collection of tangible assets that there is not. so long, under different competitive conditions, we could employ over 1,000 people. “-Berkshire Letter 1985

Disclosure: The author has no actions mentioned.

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