An Analysis of Book Values

A deceptive metric with mildly useful characteristics

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A few weeks back, I wrote about Free Cash Flow and how I went about back-filling the free cash flow data for the companies in my portfolio. While doing so, I spent some time updating the Book Values of each of the company in my portfolio too. This post is a quick summary of what I found there.

The book value of a company, also known as the net asset value or shareholders' equity, represents the total value of a company's assets minus its liabilities. It is the value of a company's equity according to its balance sheet. In other words, it is the amount that would remain if all of a company's assets were sold off and all of its debts were paid.¹

In theory, this should be a powerful metric that could set the cap on any losses that you might incur in an investment. For instance, if you buy a company whose book value per share is $100 for $110 in the open market, you would like to believe that if the stock drops below $100, say to $90, there would be enough buyers coming forward to buy the stock in order to cease operations, strip the company down and selling the assets and pocketing a cool $10 in the process, as the assets (minus the liabilities) should net $100 as per the book value metric.

Reality, however, can’t be more different from truth. Accounting principles allows various things to show up in book value that won’t be converted into cash in case you ever go to sell the company in whole, or in pieces. One example is Goodwill², which is recorded as the difference between an acquisition price and the book value of the acquired, when an acquisition occurs. The acquisition might or might not ever produce the same value as what it was purchased at, and hence “goodwill” on the Assets side of a balance sheet could be just smoke.

While we talk about the pessimistic scenario, the opposite can also be true - the book value far underestimates what the company’s assets might be worth. In fact, for many companies that have been around for years, this would often be the case. Imagine a company that might have purchased a factory on a piece of land, whose land value might have appreciated many fold over the years, but might be carried on the books at the acquisition price (minus depreciation of the factory itself).

To be clear, Book Value is different than Intrinsic Business Value, as written by Warren Buffett in the 1983 Shareholder’s Letter:

"Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.

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 input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value."

All this says is that book value in itself is not a very useful measure. However, the ratio between price of a stock and book value, measured as Price/Book ratio might get more interesting, again, not in isolation, but in comparison to other companies and competitors.

Findings

The Lows

There are 3 companies in my portfolio with a P/B of less than 1:

1. Anhui Conch Cement (HKG:0914); P/B: 0.611

2. Fresenius SE & Co KGaA (ETR:FRE); P/B: 0.712 (last post)

3. Sumitomo Corp (8053.T); P/B: 0.874 (last post)

The Highs

There are 8 companies in my portfolio with a P/B of over 10:

1. Costco Wholesale Corporation (NASDAQ:COST); P/B: 10.994

2. PepsiCo, Inc. (NASDAQ:PEP); P/B: 14.463

3. Microsoft Corp (NASDAQ:MSFT); P/B: 14.641

4. Visa Inc (NYSE:V); P/B: 15.138

5. Lenovo Group Ltd (HKG:0992); P/B: 19.636 (last post)

6. Amgen, Inc. (NASDAQ:AMGN); P/B: 32.695

7. Mastercard Inc (NYSE:MA); P/B: 56.737 (last post)

8. Home Depot Inc (NYSE:HD); P/B: 197.979

The Variants

Even within the same sector, and similar looking companies P/B can vary a lot. Take Pharma sector, for instance, where the P/B ratios of the 5 companies in my portfolio vary all the way from 1.215 to 32.695

1. Sinopharm Group (HKG:1099); P/B: 1.215

2. UCB SA (EBR:UCB); P/B: 1.802

3. Novartis AG (SWX:NOVN); P/B: 3.309

4. Roche Holding AG (SWX:ROG); P/B: 8.322

5. Amgen, Inc. (NASDAQ:AMGN); P/B: 32.695

The Rangebound

However, in some sectors, P/B can be within a tight range.

1. Take a look at Financial companies (excluding financial platforms like Mastercard and Visa) and the P/B is in a very tight range, even though they are across 3 different continents:

   1. Legal & General (LON:LGEN); P/B: 1.239

   2. Challenger Ltd (ASX:CGF); P/B: 1.341

   3. State Bank of India (SBID.IL / NSE:SBIN); P/B: 1.416

2. Or Utilities:

   1. Enagas SA (BME:ENG); P/B: 1.562

   2. Red Electrica Corporacion SA (BME:RED); P/B: 1.82

Summary

Book Value is a theoretical accounting metric that can’t be used in isolation. Combined with sectoral comparisons, it might present minor insight in evaluating companies, but any attempt to use it beyond a small weightage is not worth it unless you understand the nuances and veracity of the metric at hand.

1. This paragraph and this alone was generated by ChatGPT. Emphasis mine.

2. From ChatGPT: In accounting, goodwill represents an intangible asset that arises when a company acquires another business for a price greater than the fair value of its identifiable net assets. It reflects the premium paid for the acquired company's reputation, brand recognition, customer relationships, intellectual property, and other non-physical assets that contribute to its value.