Understanding Book Value: What Buffett REALLY Means About This Accounting Metric


Warren Buffett is probably the most watched investor in the world. Many asset managers seek to emulate its movements. This is not surprising considering its impressive track record of generating above-average returns for the U.S. stock market for six decades. So when the Sage of Omaha seems to be throwing a favorite measuring tool out of his scan kit, it’s inevitable that serious investors will pay close attention to it. For some, Buffett recently hinted that book value was an outdated metric. Not so fast, says financial journalist Ruan Jooste, who has dissected the details in this fascinating analysis of why Buffett rethought book value’s place in equity analysis. This article is republished on Biznews courtesy of The Daily Maverick, where it first appeared. – Jackie Cameron

By Ruan Jooste

For more than 50 years, Berkshire Hathaway chairman Warren Buffett was perhaps known as the biggest fan of “book value”. He followed the Benjamin graham school of value investment, so he didn’t just grow up with that mindset – it was in his blood.

Over the years, Buffett identified stocks that were unduly priced below their book value (intrinsic value) by his market peers and expressed his belief that the market would end up favoring those quality stocks in the longer term. , what they did.

Coca-Cola is a good example. The beverage company is Berkshire’s third-largest holding, more than 30 years after first joining the portfolio, and has grown almost 16 times over the following years taking into account dividends.

Buffett was never concerned with the complexities of supply and demand in the stock market. Paraphrasing his quote:

In the short term, the market is a voting machine; in the long run, it is a weighing machine.

As stated in Berkshire Q2-2019 10-Q, the book value at June 30 was $ 382.5 billion. Adding in a gain of $ 6.3 billion from changes in equity values ​​and $ 6.5 billion in operating profit, he forecast a book value of $ 395.3 billion for Q3- 19.

Longtime readers of its annual letter to shareholders would have noticed a significant change in the melody of the Oracle of Omaha in 2019. For nearly three decades, the initial paragraph presented the percentage change in book value per share of Berkshire, but in March he wrote:

“Now is the time to abandon this practice,” he said, “as the annual change in Berkshire’s book value – which makes its farewell appearance on page 2 – is a measure that has lost momentum. relevance it once had. “

Does this mean that the mantra of investing in value, which the Buffett groupies have followed religiously for many years, is no longer relevant? Has book value as a measure of valuation of listed companies become a mere bookkeeping exercise?

Not so fast.

Protea Capital Management CEO Jean-Pierre Verster says that interpreted correctly, book value remains an important part of the investor’s value repertoire.

And for Berkshire, the investment universe has evolved from simply being rooted in low-cost investments relative to book value. The group’s minority buyouts of Big Tech stocks like Apple and Amazon have almost everything to do with this – an industry Buffett has been quite opposed to in the past.

Berkshire increased its stake in e-commerce giant Amazon by 11%, the Nebraska-based holding company revealed in a Securities and Exchange Commission (SEC) filing in August for the second quarter. Berkshire now owns 537,300 shares of Amazon, worth $ 947 million.

Berkshire also owns around 252.5 million Apple shares.

“Never invest in a business that you cannot understand.”

“The risk comes from not knowing what you are doing,” everyone remembers of Buffett after the dot-com bubble burst in 2000.

Verster says Berkshire has gradually transformed from a company whose assets were once concentrated in majority-owned operating subsidiaries, which according to accounting rules would have been consolidated line by line, reflecting the transparent book value on the group’s balance. . balance sheet, into an investment holding company, due to the significant accumulation of investment securities on the group’s balance sheet, which does not reflect the book value of transparency.

Second, while book value accurately reflects the fair value of tangible assets such as cash, it fails to capture the full value of intangible assets such as brand value or intellectual property, says Verster, who are generally under-represented on a balance sheet. This can become a significant distortion of book value in the traditional sense, increasingly in a digitized and service-oriented world, where valuation is not based solely on tangible assets such as factories, machinery and real estate.

A third point, says Verster, is that it is likely that over time Berkshire will be a significant repurchaser of its own shares, with transactions that will take place at prices above book value but below estimated value. intrinsic value. The calculation of these purchases is simple: each transaction increases the intrinsic value per share, while the book value per share decreases.

This combination causes the book value dashboard to become increasingly disconnected from economic reality due to share buybacks.

After promising comments at Berkshire’s annual meeting in May, Berkshire repurchased just $ 442 million of shares in the second quarter, compared to $ 1.7 billion in the first quarter. Importantly, however, these buybacks took place above Berkshire’s book value.

It can’t be overstated how big a change this is from Buffett and his longtime partner Charlie Munger, and what it means for the age-old tradition of investing in value.

“For Warren Buffett, giving up investing in value is as if the Pope renounced his faith: an act so great that it is important enough to provoke a crisis of faith even among the most faithful of the faithful”, Write the Financial Time.

But this is not a loss of relevance to the book value, but perhaps simply a change in an investment style.

Verster says there is still a lot of value in using the justified price / book multiple where the ratio is based on Gordon’s growth model. It uses the sustainable growth rate of the company and the observation that the expected earnings per share equals the book value multiplied by the return on equity.

It’s pretty technical, but the point is not to write off the book value just yet. The valuation model is subject to risk and input volatility like any other, and calculating intrinsic value in this way may not be a guaranteed way to mitigate all losses for a portfolio, but it gives a clearer indication of a company’s fair value, which is essential when selecting stocks that you intend to hold for the long term. BM

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