Issue 200, 24 May 2006
Investor's College The beauty of book value In the fourth instalment of our value investing series, we get down to the nuts and bolts of valuation. In the second instalment of this series, in issue 198/Apr 06, we saw that shares are worth the present value of the future cash they can generate for their owners. We can either look at this cash in terms of the dividends paid out, or in terms of the net cash flowing into the company. In the mystical world of economic theory, where all capital is created equal and markets are efficient, it actually makes no difference because (a) shareholders’ money is shareholders’ money whether or not there’s been a board resolution to pay it out, and (b) all investors and companies should be assumed to make the same returns and should therefore discount their cash flows at the same rate. In spite of a few shortcomings (one of which we’ll come to shortly), this theory does at least provide a framework for comparing different companies, whatever they do with their cash. And if you give an analyst a theoretical framework, he or she will give you a 15-page spreadsheet. After all, if a company is worth the present value of its future cash flows, then why not put together a giant sum, calculating all those cash flows, discounting them back to their present value and totting them all up. These sums are called ‘discounted cash flow’ calculations and they’re all the rage these days (though curiously they were not nearly so popular before the advent of the computer). Crazy numbers In practice, though, these sums aren’t worth the space they take up on your hard disc. First of all, you can get so wrapped up in the calculations that you forget to spend enough time actually thinking about the numbers you put in. Secondly, as you multiply rough estimates together, they get rougher and rougher until they’re of little use. Finally, when you do get an answer, there’s a temptation to award it too much credibility simply because it’s been spat out by your elegant spreadsheet— and this is despite the fact that you’ve probably gone back a few times to tweak your inputs to get a more sensible answer (that is, the one you were looking for) after that first crazy number that came out. The better bet is to stick to using a few simple valuation tools— such as ‘price to book’, dividend yield and PER— and then allow a fat margin of safety. But it’s essential to see these tools purely in the context of helping you reach an estimate of the present value of a company’s future cash flows (which is why we’ve been wittering on about these cash flows for the past few issues). The simplest tool of all is the price to book ratio. You get it by taking a company’s market capitalisation and dividing by its net asset value (or ‘book value’). There are two main justifications for using it to estimate value. The first is that the book value represents what’s been paid by the company for all its stuff, so it might at least be an indication of its value— after all the company could flog it all and give the money back to shareholders. The second justification is rather more esoteric, though it amounts to the same thing, but it warrants a mention only because it explains things in terms of the fundamental definition of value. The theory goes that the book value is the company’s base of capital on which it makes a return, and since we should assume it will make the same return as its shareholders (remember this from earlier?), then the sum of a company’s capital represents its value to shareholders. Accounting confusion The beauty of book value is in its simplicity, but there are a couple of problems. The first is that the book value doesn’t in fact represent the value of a company’s assets; it represents what the company paid for those assets, less an arbitrary charge for wear and tear over the years, and plus or minus the odd bit of accounting confusion. So you have to be careful about the assets you include in your book value and the values you give them. Plant and machinery dedicated to a declining industry might have a much lower value than that stated on the balance sheet. Other assets, such as cash, have a more definite value. In between, there are things like inventory and debtors, whose value will depend on how confident you are that they can be converted successfully into cash.
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Some assets, such as property, might be understated, and some valuable ‘intangible’ assets, such as brands, goodwill and intellectual property, might not even show up at all. The Coca-Cola Company had a book value of US$29bn last year, but according to Interbrand its main brand is worth US$68bn. Even that may be on the low side if the company’s US$103bn market capitalisation is anything to go by. So it’s all a bit circular. We say a company is worth the value of its assets because of what they can earn for us, but then we value those assets according to what they can earn for us. All roads eventually lead back to the fundamental truism that a piece of capital is worth what it can earn. All capital not created equal Which gets us to our second problem— that companies and investors most definitely don’t all make the same returns. Some companies consistently make returns far above what others manage, either because of competitive advantages or good management, or both. Economic theory says these factors should be ironed out over time, but in practice they can hang around for ages. All things being equal, then, a good business making high returns on capital will justify a higher price to book ratio than a poor business making low returns. So the advantage of price to book is that it is quick and easy; the disadvantage is that it often won’t tell you much about a company’s value. But it can often provide useful pointers. It’s a good sign, for example, if a company is priced well below a conservative valuation of its assets (particularly if it also makes a decent return on capital). It’s even better if a company is selling below the value of its net working capital (cash, inventory and debtors, less all liabilities). And best of all is if a company is selling at less than its cash holdings, less all liabilities, as was SecureNet when we upgraded it to an outright Buy in issue 101/Apr 02. James Carlisle
C o p y r i g h t © 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.
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