Why book value has lost its meaning


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BABY-BOOMERS You may remember, perhaps with nostalgia, how the golden arched sign outside every McDonald’s restaurant proclaimed how many customers the chain had served. As they became adults, their number continued to climb: 5 billion in 1969; 30 billion in 1979; 80 billion in 1990. Jerry Seinfeld, ironic columnist of the banal, was moved to ask: “Why does McDonald’s still count? Do we really need to know every last burger? Just put up a sign saying, “We’re doing great. “

Counting has stopped. The signs simply said, “Billions and billions served.” If that sounds unnecessarily vague, sometimes that is how the counting business is. Many of the largest U.S. companies, including McDonald’s, report negative book value, a measure of a company’s net assets. Many others have a book value that is low relative to their market value: their stocks appear expensive on a price-to-book basis. In large part, this is due to the complexity of valuing a company’s assets in the digital age. But the result is that price relative to book value is a poor indicator of a stock’s true value.

Stockpickers make a distinction between the price of a stock and what it’s really worth. Price is a creature of fickle feeling, greed, and fear. Value, on the other hand, depends on the capabilities of a business. There are various abbreviated metrics for this, but true “value” investors place the most importance on the price-to-book ratio. It is the basis for inclusion in benchmarks such as the Russell Value Index. Countless studies have shown that buying stocks at a low book price is a winning strategy.

But not recently. For much of the past decade, value stocks have lagged the mainstream market and far behind “growth” stocks, their antithesis. Perhaps this is because, as the industrial age gives way to the digital age, the intangible assets that increasingly matter are not easy to value. The tangible world is easier. Factories, machinery, land, and office buildings count as fixed assets on a business’s books because they will generate profits for many years to come. Finding value for them is a pretty straightforward affair – that’s what the company paid for. This value is gradually amortized (amortized) over time to reflect wear and tear and obsolescence.

These fixed assets, as well as current assets (cash, inventories of unsold goods, etc.) generally constitute the bulk of the book value. The problem is what he leaves out. Today, the value of a company lies as much in its reputation, its processes, the know-how of the staff and the relationships with customers and suppliers as in the tangible assets. It is notoriously difficult to assign a book value to these intangible assets. By their nature, they have fuzzy boundaries. Not every dollar of R&D or advertising spending can be attributed to a well-defined asset, such as a trademark or patent. This is largely why, with few exceptions, these expenses are treated as current expenses, such as rent or electricity.

Price is increasingly detached from book value. The median price per book of S&P 500 shares is 3.0. But many well-known companies, whose competitive advantage is based on trademarks or patents, have much higher ratios or even negative book values ​​(see graph). McDonald’s has considerable brand value, which is not reflected in its balance sheet. It also has fully depreciated real estate assets.

The effect of mergers is to make things darker. If, for example, one company pays $ 100 million for another that owns $ 30 million in tangible assets, the remaining $ 70 million is recognized as intangible assets, or as brand value, if that can be measured. , or as “goodwill”. It skews comparisons. A company that has acquired brands by merger will have those reflected in its book value, says Simon Harris of genetically modified organism, a fund management company; a company that has developed its own brands will not. Share buybacks make things even darker. For any company with a price-to-book ratio greater than one, a buyback will decrease the book value proportionately more than it will lower the value of the outstanding shares. The price at reservation therefore increases further.

Some have called for the accounting rules to change. But the more leeway a business has to turn day-to-day costs into capital, the more opportunities there are to play with reported profits. Better to encourage disclosure of expenses that add intangible value. Analysts can then form their own opinion. Mr. Harris believes that adjusting the book value to reflect the past R&D and ad spend allows for more useful comparisons between actions. It is not a perfect gauge. But no single metric, whether it’s the price per booking or the billions of customers served, can ever say it all.

This article appeared in the Finance & Economy section of the paper edition under the title “A basket of intangibles”


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