Has book value lost value?


Director, Banyan Tree Advisors

December 20, 2011

Many analysts dismiss book value as a rearview mirror that does not reflect a company’s intangible assets. Even so, it can be a good first-cut method to screen stocks for investment ideas.

While discussing a stock with a research analyst recently, I mentioned to him that the company’s book value per share was Rs 100 as against a stock price of Rs 40. He looked at me quizzically and said, “Surely you don’t believe in that old-fashioned stuff!” That’s no stray remark from an eccentric investor, but increasingly the view held by most analysts these days. But before we consign “old-fashioned” book value to the dustbin, let’s explore why it seems to have
outlived its relevance to investors.

A number of reasons are cited. Book value, many analysts maintain, is merely an accounting concept, which only captures the historical value of all the assets of a company. And, so, rather than obsessing with the rearview mirror, we should be looking at the road ahead — the future cash flows from the business in question.

What use are a company’s assets, anyway? For all you know, all the machinery may be well past its useful life. Besides, book value does not account for the intangible assets of a company, such as brand equity or distribution strengths.
And accountants have limited means of capturing the value of employees, assets that move in and out of the company premises every day.

With rapid advances in technology, the value of historical assets seems to be becoming more and more difficult to predict. For all practical purposes, therefore, the P/BV or price to book value per share of a stock has been written off from the list of ratios that investors might use to screen stocks for investment.

While bowing to all these reasons cited to give good old book value a decent burial for having served investors well for 30-odd years, I must differ with fellow analysts who believe that P/BV is a meaningless number in this day and age. The
same analysts who swear by RoE (return on equity) — measured as profit after tax divided by net worth — and cheerfully use it to gauge the investment potential of a stock.

RoE measures the overall profitability of an enterprise, and if its RoE is lower than the rate of interest, it’s seen as destroying value. What most analysts seem to forget is that the denominator of this ratio (RoE) is net worth, which is nothing but the book value of the company. And any analysis of a stock based on its return on equity must include an evaluation of its price to book value.

To give you an example, let’s assume the following of company A:

  • A return on equity of 20 per cent, with a book value per share of Rs 100;
  • Last year’s EPS of Rs 20 (implied by the 20 per cent return on equity);
  • Stock price of Rs 50.
  • The company has recorded a steady profit growth of 20 per cent in the past five to seven years, but its prospects for the current year are in doubt owing to the price pressure on one of its key products;
  • Analysts expect the company to post 20 per cent lower profits this year. That is, an EPS of Rs 16.

Is this company a worthy investment for the long-term investor?

Most of my fellow analysts would conclude this is not a fast-growing company, and immediately discard it as a potential investment. They would be more interested in company B that has:

  • A book value of Rs 100
  • An EPS of Rs 30
  • Grown at 100 per cent over the previous year
  • And is now trading at Rs 3,000.

In a market obsessed with growth, it’s difficult to blame these folks. True, a company growing at 100 per cent is superior to one that shows negative growth, but the investor must also ask if this growth is sustainable and, therefore, if the
price he pays for high growth is worth it.

To take a short-term view of the market would be to react to the lower profit expectation from company A and ignore the fact that at Rs 50, or half the book value, I can buy into a company with an RoE of 16 per cent despite the temporary
drop in profits. Since RoE is calculated on book value, it’s like investing in a business that’s generating an RoE of 32 per cent. I can see the financial analysts among you groan at my simplistic analysis, but it’s a fair enough approximation, I

Investors are much more comfortable dealing with the PE (price to earnings) ratio because of its obvious simplicity. However, among the most important things to take into account while using the PE ratio is the year for which earnings have been considered. The number could be very easily distorted by exceptional earnings in the year in consideration. One needs to be sure that these earnings numbers are representative, and that sustainable long-term growth can be
predicted on this base. Price to book value may be a more reliable tool to use, particularly if the enterprise is at least moderately profitable.

There is a large number of stocks in the market today that quote at high discounts to book value, generate a return on equity that’s higher than the interest rate, but are ignored by the market simply because they do not belong to the “hot” IT or pharma sectors. Here’s a small list that may interest you:

Another useful ratio to look for is dividend yield (dividend per share divided by stock price), which has an intuitive appeal for value investors. Because this investor has to often wait for the price of the stock he owns to come up to its

intrinsic value, dividend yield works like a reward for the wait, besides providing a lot of downside protection to the stock. The important thing to remember while trying to look at price to book value as a means of screening stocks is to avoid ‘value traps’, that is those companies where the value is being progressively destroyed by poor or dishonest
management. It is very difficult to unlock value in these companies without an extended court battle — a nightmare in the Indian situation.

While I do not advocate buying stocks on the basis of book value alone, it can be a very good first-cut method (when used along with the return on equity and dividend yield) to screen a large number of stocks for investment ideas. So, before you throw book value out the window, remember that history is a great pointer to how the story will pan out for your stock.