speedybure (< 20)

Price to Book Value: The inherent problems that every investor should know

April 24, 2009 – Comments (1) | RELATED TICKERS: RTH , WMT , M

Book value to be begin with is already flawed due to its compositions/ asset classification, but a host of problems could arrive numerous industries (more so than others and some not at all) in a recession.

First of all let us define book value then breakdown assets and liabilities individually.

Price to Book: The mainstream definition is total assets/total liabilities

Asset component: The biggest problem lies in the fact "intangibles" can't be quantified. It is arbitrary and various according to market price and the bid/offer/purchase price of other firms. The assets show up in plant property and equipment generally speaking, so the synergies "intangibles represent", if present, will show itself through future earnings power. 

Other problems may arise during a recession in current assets. This is the perfect time to discuss this matter due to the current recession that will likely last for a lengthy period from present day. Inventories, most notably retail will carry over-valued inventories on their balance sheet. But if you haven;t noticed, there are fire sales going on. This does show up in earnings but the existing inventories are not immediately adjusted to fire sale prices. account recievables can also pose a problem, especially if these are to be payed by a small group. A/R already have a reserve for bad loans(recievables) based on their historic average, therefore this is understated. The loan loss reserve should be adjusted upward and deducted from assets.(Its better to be conservative than agressive). 

Liabilities: This is where most people fail to account for. To keep this short and to the point, i will continue to talk about the retail industry although these hold true for a host of others. First of all balance sheet debt, which is more common than anyone would think. Another problem is the fact retailers and others have large lease obligations, which are usually anywhere from 4-10 years and range from 10-200 million for small and midcap retailers and 200m to 500m and even more for the largest. Lets not forget pension obligation.. Yes those are a liability. This should all be added to the balance sheet.

To sum this up, book value can be a terrible measure of the real liquidation value. Assets are often overstated and liabilities understated. Obviously the degree varies and in some cases does not apply except for intangibles. To be prudent deduct intangibles and go through the annual report and add at least half of the liabilities that failed to make it to balance sheet.