Best Practices for Book Value Analysis

(Many investors look for book value as a way to value an investment. Photo by Joe Crawford of Moorpark, CA, USA – Flickr, CC BY 2.0, source link)

By John Leonard, CFA

Building on the author’s recent experience with free cash flow analysis, this edition focuses on a company’s net worth at any given time rather than the ability to generate income over time. time.

Like FCF, book value (and by extension P/B) is one of the best – and often misused – ways to value a stock.

Below, I go over each of the top assets on the balance sheet with “best practices” in bullet form. For the sake of simplicity, I am focusing only on the asset side of the balance sheet, since it is traditionally accepted to simply use the total liabilities “as is”.

Cash/cash equivalents, marketable securities and investments

  • Although the cash figure is correct at any given time (for example, December 31, 2017), it will obviously fluctuate depending on various factors. Excluding equity/debt issuance, one of the main drivers is FCF. If a company is FCF neutral or positive, it is reasonable to value silver at 100 cents on the dollar. If it’s burning cash, a discount may be warranted.

  • See footnotes to see what marketable securities or short-term investments represent. Funds invested in US Treasuries are safer than corporate bonds or MBS.

  • Check non-current assets for possible “hidden” sources of cash. For example, a company will sometimes have “long-term investments”, which may be stocks or bonds not classified as current assets. Although these are less valuable than “pure” money, it may be appropriate to count this asset as “cash”. Note – it’s a good idea to explain your thought process if you include non-monetary figures (such as investments) so that it’s clear to readers.

  • When in doubt, go directly to the SEC or company filing to find financial numbers. Data providers sometimes give the wrong figure or exclude certain categories of cash (such as short-term investments).

Accounts Receivable

(Not known for a particularly fast cash conversion cycle. By BeenAroundAWhile at English Wikipedia, CC BY-SA 3.0, source link)

If the company you are analyzing uses the “Trust God – all others pay cash” policy, you can skip this section. There’s a reason you never see a kid holding a lemonade stand and muttering that they’ve been “crushed” by the DSO increase.

  • A large balance of receivables can create or destroy value. For the former, its reduction will generate cash flow while a rising balance will consume money.

  • Look at the trend – not just the ending balance at any given time – to get a better picture. A high balance that has been decreasing might be better than a small balance that is increasing.

  • Are the sales seasonal? Does the balance increase significantly one quarter and then decrease the next? This must be taken into account.

Inventories

  • Look at ratios such as days inventory to see how long inventory stays on the balance sheet. A high and/or increasing number could be cause for concern.

  • Stocks are usually given a discount in a liquidation analysis – if you assume the company would receive a high percentage of the reported balance sheet value, this should be taken care of.

Prepaid expenses

  • Although this is more valuable than goodwill/intangibles (see below), it’s not really an asset that can be liquidated (you can collect a receivable, you can sell inventory, what do you do with a prepaid insurance premium).

Fixed assets

  • This is likely to be a source of hidden value. As REIT investors are well aware, due to accounting rules, assets are presented on an amortized basis whereas land is never marked up – this can result in an understated book value. Obviously, there are a number of factors that determine how much you should adjust this value (location, type of property, building age, etc.). This is where recent compositions can come in handy. Suppose Company A owns 1,000 acres of land valued at $1,000 per acre on the balance sheet. Company B has just sold 50 acres right next to Company A’s land for $10,000 an acre.

Goodwill/Intangible

(The original cryptocurrency. Photo by Martiniturbide – Own work, CC BY-SA 4.0, source link)

  • In my opinion, this is one of the main ways that P/B is misused. For example, company XYZ has a market cap of $100 million and equity of $200 million for a P/B of 0.5x, so it appears undervalued on an absolute basis. However, what if there is $150 million of goodwill? The P/TBV is 2x. When evaluating balance sheet assets, the following is a good (only half-joking) guide: Cash > Accounts Receivable > Inventory > Chuck E. Cheese tokens you’ve saved for sentimental reasons > goodwill.

  • Some sectors (e.g., technology or healthcare) typically don’t compromise book value at all, so a “high” book value is either less alarming or meaningless because the focus is on earning power and companies generally have few durable assets (compared to say a manufacturer).

  • Note – patents, trademarks, brand names, etc. have value and should not be lumped into the general goodwill/intangible category.

Examples of evaluation

P/B and P/TBV can be used on an absolute basis (eg company XYZ is trading at 0.5x TBV) and/or on a relative basis (eg company XYZ is trading at 0.5x TBV). pound and its peers are trading on average at 1.0x).

To further reinforce the thesis that the discount to be reserved for a security will be reduced, it is useful to show:

  • Its historical valuation range. For example, saying the stock is undervalued at 0.5x book value is less persuasive if it has traded at an average of 0.6x book value over the past five years.

  • Catalysts to close the discount, such as an asset sale (above reported book value) or liquidation.

Conclusion

Just because P/B is one of the simplest valuation metrics (compared to EV/EBITDA) doesn’t mean it’s useful. However, it is often because of this simplicity that it is often misused. By following the best practices above (which are by no means exhaustive), investors can uncover hidden values ​​and avoid (or avoid) value pitfalls.

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