Does book value even matter?

Book value is praised as the one true metric that matters to investing, and derided as an accounting fiction.  Book value is fascinating, on one hand it's an accounting creation, yet on the other hand it's a very rough estimate for the tangible value of the company.

At the most basic level book value is the sum of a company's assets minus all liabilities.  What's left over is termed equity, or a company's book value.  A company's book value isn't anything specific, it's just the remainder from subtracting two values, assets and liabilities.

Value investors place a lot of emphasis on book value, for most book value represents a tangible high water mark for an investment.  What's that you say, you are a value investor but don't care about book value and only growth?  My friend you are a value GARP investor, you're looking for cheap growth, you're in good company, many "value" investors are really trying to buy growth cheap.  Read on to discover how those of us with plaid sport coats and elbow pads view book value.

Book value is at best an estimate, an estimate of what equity holders tangibly own in a company.  In theory if a company were to pay off all liabilities and distribute the remaining assets investors would receive book value.  In reality this never happens, and when it does it's a messy affair, at times what's distributed is far in excess of book value, and other times far below.

Two companies could report $100m in equity, at the first company the value might be realistic, and at the second nothing more than a faint hope.  A company's book value is determined by the composition of its assets and liabilities.  I have a friend who runs a factoring business, he sent me an email recently discussing how many client receivables are hopelessly overstated and will most likely never be collected.  He brought up a good point, a point that Graham discussed in Security Analysis.  In all companies liabilities are real, whomever a liability is owed will ask for it to be settled at some point, but assets are never sure, cash is sure, but the value of receivables, inventory and property is often a best guess.  While inventory might be overstated, a debt on the balance sheet is never wrong.  I have yet to read a financial statement with the note "We borrowed $10m, but the lender decided they only wanted $9.5m back."

A company's book value is not precise.  The balance sheet is merely a snapshot in time, but thankfully most items captured on the balance sheet are slow to change.  A company's earnings might fluctuate quarter to quarter or year to year, sometimes slowly, and sometimes dramatically.  Book value rarely fluctuates quickly, the value it captures is slow moving and rarely changing.  Cash is valued the same five years ago as it is today and as it will be in twenty years.  A manufacturing company's building is probably worth the same today as it was ten years ago.  Until a company decides to sell their assets and determine what the market will pay book value is the best estimate we have.

Some items captured in book value are clearly understated.  Companies are required to depreciate property, plant and equipment and scheduled intervals.  This depreciation is supposed to capture the fact that property and machinery decline in value as they are used.  Depreciation is a rough metric, at times it's close, but with certain industries it clearly misses the mark.

My brother works for a manufacturing company whose machinery is from the 1930s and 1940s.  The company's needs are simple and the machinery is essentially bulletproof.  The machinery has long been depreciated, yet continues to have years of useful service left.  I have worked in a number of manufacturing facilities where I've seen similar things, although not to the same level.  Machinery manufactured in the 1960s and 1970s is commonplace in many American factories.

A company I own was an example of this recently, Bowl America announced that they had sold an underperforming facility for more than $2m.  They subsequently stated that the facility was held on the books for $230,000, quite a difference!

What I find very interesting is that while equity investors give book value a passing thought bond investors and bankers pay the utmost attention to book value.  A creditor has a lien on the company's income stream, but if for some reason a company can't pay they need to determine if they'll be able to collect on the money they lent.  In a bankruptcy or distressed situation a creditor might force a company to sell off some assets and return the cash to creditors.  An asset sale moves theoretical values to the tangible column.  A sale shows the world what the company thought a building was worth, and what others thought it was worth.

I like to see companies where book value is growing over the years.  When book value grows equity investors own more of something each year.  A high growth company could earn a lot of money, but need to re-invest all of it for continued growth.  If the company fails to invest growth slows, and often investors flee.  An investor in such a company is betting that growth will continue, but they don't own anything more than they did a year before.

When a company grows book value they show that they earn enough to cover costs, and have something left over.  Companies with growing book values selling at discounts are often incredible investments.

The one unstated item in this post is the quality of assets, I briefly mentioned it above, but it deserves further discussion.  Let me start with two examples.  Value investors are often afraid of banks, they seem complex and mysterious.  A claim I've heard is that bank investors don't actually have a claim on a bank's equity because it's held for regulatory purposes.

I would argue that banks are the ultimate liquid and commodity investment.  There are over 7000 banks in the US, banks routinely buy and sell loan portfolios to each other, as well as branches.  A bank with a good loan book and good branches could sell their loans and branches at par fairly quickly.  They could then take those proceeds and distribute them to depositors leaving equity holders owning the company's book value.  Due to regulation book value consists of cash and securities, highly liquid salable items.  Whereas on the surface a bank might be confusing, a bank's equity capital is very simple, and often very liquid.

The second example is a company floating around the blogosphere, Premier Exhibitions.  The company owns the Titanic artifacts, which a judge determined were worth $190m.  The company sells at a wide discount to the artifact values.  When looking at the book value of Premier it consists of the Titanic artifacts and not much else.  Clearly equity holders are betting that Premier will be able to sell their artifacts at close to their valuation.  They might be, but I am positive the market for $190m worth of Titanic artifacts is much smaller than the market for commodity items such as office buildings, or loan portfolios, or bank branches.

For book value investors the question to ask is what does book value consist of?  If a company is selling at a discount to book value is it because book value is a hard to value or a hard to sell asset?  Is it because the market doesn't understand how to value the assets?

Talk to Nate about book value

Disclosure: Don't own anything mentioned specifically, generically I own a number of bank stocks.