When a low book value can be misleading


Some say book value has lost its meaning over the past decade as there are myriads of stocks with extremely low or even negative book value like McDonald’s that have consistently outperformed the market. Has it lost its meaning? What’s going on here?

For traditional value analysis tools, such as the net-net or the price-book ratio, this is a matter of concern, as these tools are intended to assess the operational profitability of companies over time. For example, Mattel Inc (NASDAQ: MAT) has incurred losses over the past two years and, as a result, decreased the company’s retained earnings, resulting in a decrease in book value and book value. tangible negative.

However, the relevance of these tools is questionable for different companies in a different context. While the measure is still useful for certain types of businesses, some investors have even gone so far as to suggest lowering the book value altogether.

Regardless of who is right or wrong, let’s explore some situations or actions that can lead to low or negative book value.

1. Buyback programs or dividends: At the end of 2017, Qualcomm (QCOM) had a total share capital of $ 30.7 billion, while at the end of 2017 it was reduced to less than $ 1 billion thanks to $ 22.5 billion in share buybacks and $ 3.5 billion in distributed dividends. The impact on financial statements would be a reduction in cash and short-term investments on the asset side, while retained earnings, which is the amount of income accrued after payment to shareholders, would be reduced. This, in turn, will make the business look good in terms of assets, equity or invested capital.

2. Goodwill impairment test: Goodwill is a type of intangible asset created through merger and acquisition activities and recorded when the carrying amount is greater than the fair value. It is subject to an annual impairment test. Perhaps one of the most recent examples would be General Electric (NYSE: GE) which wrote off $ 22 billion in 2018, which contributed to the “demise” of $ 100 billion in book value.

3. Divestments: This is perhaps one of the most obvious reasons why and how book value can be reduced. This can be done to unlock the value. For example, eBay (EBAY) had a book value of almost $ 24 billion in 2014, which was reduced to almost $ 6 billion in 2016 due to the divestment of PayPal (PYPL). Both actions ended up doing more than well.

4. Real Estate Ownership Companies: O’Reilly (NASDAQ: ORLY) is one of the largest specialty retailers of automotive parts, tools, supplies, equipment and accessories in the United States, selling their products for DIY enthusiasts and professional customers who provide services. Even though it is one of the best stocks on the S&P 500 over the past decade, its book value has declined over time. These companies operate as a real estate investment partnership and of the 5,219 stores they operated as of December 31, 2018, O’Reilly owned 2,119 stores and leased 3,026 stores. This is a giant real estate company whose property value increases over time while being required to report the value at original cost after depreciation. This leads to a huge misunderstanding about their business model and similar businesses.

5. Companies based on intangible assets: For many companies based on human capital, such as software companies and consulting firms, it is common to have low tangible assets, which results in low or low book value. negative. However, for companies like LVMH Moet Hennessy (LVMH), aka Louis Vuitton, how do you quantify the value of their brand? There is no scientific way to do it. For brand-based businesses, it’s also common to see a depressed book value.

6. Negative other comprehensive income: Negative other comprehensive income may result in a negative carrying amount. There are several types of other negative comprehensive income. One is the fluctuation of unrealized losses on bonds, which can be detrimental, especially for insurance companies that take a large exposure to the bond market. Another is currency losses or unfavorable currency fluctuations, which can put multinational companies in a very uncomfortable position. A decrease in a pension plan or post-retirement benefit plan may result in a decrease in the carrying value of the related investment portfolio.

Conclusion

So how do you measure book value after all? How do you define it even beyond the definition provided by regulators?

The answer is as subjective as it gets, because the book value on the financial statement is almost always not the same as the true value of equity. To take it a step further, I would even say that although it is difficult to quantify, factors such as a large barrier to entry, wider moats in the form of patents, government regulation, reduced competition and arrears should be treated as equity in the mind of a value investor. Book value on paper can be helpful, but it should always be put into context first.

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This article first appeared on GuruFocus.


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