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Valyooo (99.82)

Where does book value fit in?

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April 26, 2012 – Comments (15)

Sometimes, I hate when I think too deeply into theory behind stock value.  Usually when I buy a company, it is cheap based on P/E, cheaper P/E than worse companies in the same sector, a very good company I think is in secular growth so I don't have to do a ton of analysis, a best of breed stock, or a stock where I think whatever caused the sell off is only 1/2 or less as bad as everybody else thinks.  Stocks make more sense logically...they produce, while bonds dont.

Where do you fit book value into your analysis of stock price value?  It is a metric I tend to ignore, unless a financial company gets way under book value since it's mostly liquid/financial assets (arguable since I am sure many banks inflate their book value).

Here is why i ask.  Say you take a stock with a price of $100 and the book value is $100, and it is growing at 10% a year and the EPS is $6, for a P/E of 16.67.  Let us leave out macro factors.  I'm not sure what the formula is for calculating future value if you add a growth rate, but manually over 10 years it would be 6 + 6.6 + 7.26 + 7.99 + 8.79 + 9.67 + 10.64 + 11.70 + 12.87 + 14.16 = 95.68 in earnings. 

Now, the reason I am going to compare this to a bond fund yielding 6% selling at par/book is because the stock reinvested all of its earnings instead of paying dividend.  6% is comparable initial return, just no growth, but I will reinvest all of the dividends into the fund to make it comparable.  You could just reinvest the bond coupons into more bonds to keep it technical so I can use my main point that when you redeem a bond you get "full book value" back (aka par), but the bond fund is easier to calculate.  $100 par, 10 years, 6% reinvested, gets you to a book value of $179.08, obviously not as good as the stock.

  BUT, what if you looked at just P/E on stocks and not book value, like most people do.  A P/E of 14 would be even cheaper, giving you EPS of $7.14 on a stock trading at $100.  let's use the same growth rate here.  But what if the book value is only $30?  Earnings after 10 years is 7.14 + 7.85 + 8.64 + 9.50 + 10.45 + 11.50 + 12.65 + 13.91+ 15.30 + 16.83, giving you 113.77 in earnings, + 30 dollar book value is 143.77.  If you "redeemed" your stock the way you "redeemed" your bonds, you would be about 30% richer in a 10 year period with the bond than with the low book value stock, even though the stock had a 10% growth rate and a higher earnings yield than the bonds yield.

So, do you use book value at all, if so where does it fit in? I never do, but maybe I should start

15 Comments – Post Your Own

#1) On April 26, 2012 at 11:32 AM, Frankydontfailme (27.45) wrote:

Is book value usually determined by independent accountants?

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#2) On April 26, 2012 at 11:51 AM, ElCid16 (93.92) wrote:

A P/E of 14 would be even cheaper, giving you EPS of $7.14 on a stock trading at $100.  let's use the same growth rate here.  But what if the book value is only $30?  Earnings after 10 years is 7.14 + 7.85 + 8.64 + 9.50 + 10.45 + 11.50 + 12.65 + 13.91+ 15.30 + 16.83, giving you 113.77 in earnings, + 30 dollar book value is 143.77.

Are you assuming that you paid $100 for the stock in year 0, and then sold the stock for $30 in year 10?  Why?

At the end of its life, a bond will indeed shift back to its par value.  But during its trading life, its par value doesn't equal its market value.  A stock doesn't have an "end of life," meaning its market value will never shift back to its book value.  You're not going to "redeem" a stock for its book value.  Ever.

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#3) On April 26, 2012 at 12:15 PM, Valyooo (99.82) wrote:

I am comparing buying a $100 stock and redeeming it for $30 to the way you would redeem a $300 bond for $100 once it reaches maturiy, and I am implying that paying $100 for a stock with $30 BV is equivalent to paying 3.33x premium of par for a bond.  This blog was not really to compare low BV stocks to high BV stocks, but more to compare low BV stocks to bonds at par.  I am trying to compare valuing stocks vs valuing bonds, and why I think in these cases bonds are a better value than stocks.

 Yes, you can redeem a stock for book value, that is what happens in liquidation.

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#4) On April 26, 2012 at 12:38 PM, ElCid16 (93.92) wrote:

Ok, let's get on the same page.  I have a few questions:

1.  What type of yield are you getting on a bond that has a par value of $100, but you're buying for $300?

2.  Why didn't you add any retained earnings to your $30 book value example?

3.  Why would a stock that just returned 10% per year for ten years go into liquidation, and thus need to be redeemed for book value?  (When would a stock nowadays ever go into liquidation?)

4.  Why are you "buying a $100 stock and redeeming it for $30"?  This sounds like a horrible investment.

When you buy a bond, you know the only principle you're getting back is the par value.  When you buy a stock, you could potentially get back much more than what you originally payed for it.  You're not getting the book value back, you're gonna get the market value back.  I think you need to get this whole "redeem a stock for book value" out of mind, no?  Maybe I'm just confused, now.

 

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#5) On April 26, 2012 at 12:43 PM, ElCid16 (93.92) wrote:

OK, a bond that is selling for $300, has a par value of $100, and has a coupon of 6% gives you a YTM of -7.1%.

Set up a scenerio that makes sense, and we'll move forward from there. 

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#6) On April 26, 2012 at 12:52 PM, Valyooo (99.82) wrote:

OK, a bond that is selling for $300, has a par value of $100, and has a coupon of 6% gives you a YTM of -7.1%.

 Remember the time when I didn't say that?

I am comparing a bond trading at par yielding 6%, to a stock with a higher earnings yield trading way over book value.

I already established that if both were trading at par/BV, I would take the stock.  My point being, is that if you don't wind up looking at BV, and you only use P/E, you miss the fact that you may be "paying over par" and therefore be getting less value than you would in a bond.

I am not sure why you don't understand what I am asking, or why you are trying to be argumentative, when I am just asking a question.

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#7) On April 26, 2012 at 1:01 PM, ElCid16 (93.92) wrote:

I apologize if I came accross as argumentative.  My last comment was a bit rude.  Sorry I can't be of more help.

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#8) On April 26, 2012 at 1:05 PM, MegaShort (99.95) wrote:

It depends whether you're a Graham value investor or a Buffett value investor.

Read this to understand why Graham would probably prefer the first company. Large book value suggests limited downside.

Read this to understand why Buffett would probably prefer the second company. The higher ROE is indicative of a stronger competitive moat and lower cap ex requirements.

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#9) On April 26, 2012 at 1:07 PM, MegaShort (99.95) wrote:

Actually, I meant this: http://www.amazon.com/The-Essays-Warren-Buffett-Corporate/dp/0966446119/ref=sr_1_1?s=books&ie=UTF8&qid=1335460024&sr=1-1

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#10) On April 26, 2012 at 3:49 PM, Valyooo (99.82) wrote:

I have read that.  I am pretty sure what he said is unrelated to what I said.  He would rather a company with a book value of 30 million earning 5 million in earnings, than a company with a book value of 100 million with 5 million in earnings.  I don't think he mentioned P/E or P/B though, I think he was referring to buying the whole company.  Because if the company does not pay a dividend, and you don't care about book value (or in fact you would rather the P/B to be sky high), then that means all previous earnings are worthless, because they are all added to book value, which you wouldn't care about.  Only the ability to earn future earnings interests you, which is kind of circular logic, since those will just get added to book value, and then becoming worthless.

Maybe I am just confusing myself...

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#11) On April 26, 2012 at 3:52 PM, Valyooo (99.82) wrote:

Take out the word stock, and think of a real  business.  If a lemonade stand was made out of a cardboard box which cost $1, and that lemonade stand made 10k a year in profit.  Then theres another lemonade stand made out of pure gold, also earning 10k a year in profit.  They both cost the same price.  Wouldn't you buy the one made out of gold?  Either way you make the same profit, and you paid the same price for it, but with one you also have a ton of gold, and with the other you only have a cardboard box.

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#12) On April 26, 2012 at 3:57 PM, Valyooo (99.82) wrote:

ElCid, I just saw your comment #4 for the first time

 

Ok, let's get on the same page.  I have a few questions:

1.  What type of yield are you getting on a bond that has a par value of $100, but you're buying for $300?

I never said anything about paying over par for a bond. I compared paying P/B of 1 for a stock, P/B of 3.3 for a stock, and par for a bond.

2.  Why didn't you add any retained earnings to your $30 book value example?

I did, that's how I got the $143.77 number

3.  Why would a stock that just returned 10% per year for ten years go into liquidation, and thus need to be redeemed for book value?  (When would a stock nowadays ever go into liquidation?)

It wouldn't, but it could. See my previous post for an example of what I mean

4.  Why are you "buying a $100 stock and redeeming it for $30"?  This sounds like a horrible investment.

Good question, which is why I made this blog.

When you buy a bond, you know the only principle you're getting back is the par value.  When you buy a stock, you could potentially get back much more than what you originally payed for it.  You're not getting the book value back, you're gonna get the market value back.

Right, but the market may do crazy things such as value it as a p/e of 1 or a p/e of 0, which is why I am talking about intrinsic value not market value. 

  I think you need to get this whole "redeem a stock for book value" out of mind, no?  Maybe I'm just confused, now.

I know you dont redeem stock for BV, this is just an exercise to compare high P/B to just buying bonds instead.

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#13) On April 26, 2012 at 5:00 PM, MegaShort (99.95) wrote:

It sounds like you have a good grasp on both the Buffett and Graham points of view.

#11, the gold is an excess liquid asset unrelated to the earnings.  If you can identify excess cash or assets which aren't contributing to earnings, more book value is always better.  One way to identify excess cash is a high current ratio (current assets / current liabilities).

#10 you're on the right track. But Buffett generally believes in equivalence between buying whole companies and buying shares of companies. He may not mention ratios like PE, PB, ROE, ROI etc. in that piece of writing, but I definitely see them between the lines.

In my opinion book value is most useful for financial companies, companies with excess liquid assets, and distressed or cyclical companies with volatile earnings.

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#14) On April 26, 2012 at 11:12 PM, Imperial1964 (97.93) wrote:

Lol, book value is most useful for financial companies if it is accurate.

 

I put a lot of weight on book value on something like a reinsurance company, when the book value of the company's holdings is the basis for their business.  There are two main parts of a reinsurance company, assets and underwriting.  I have little insight into the quality of their risk models, so book value and quality of their balance sheet are my primary criteria.

For some companies, as you point out, it may be mostly useful for a worst-case scenario assessment, but you must understand that you probably want "tangible book value" rather than simply book value, which includes intangibles like "goodwill".

 

There is, however, an interesting subject of valuing a business through "replacement cost". It works best for businesses without a "wide moat" by taking perhaps a more cynical look at businesses.

According to this method, businesses are at best only worth what they cost to replace.  Think about it, if you have a profitable business, its worth is only what it would take for me to go build a competitor from scratch.  If I learn that the manufacture of motorcycles has an unusually high return on investment, I will get a bunch of my rich buddies together and hire some engineers and build some manufacturing facilities and ramp up production until risk-adjusted returns are in line with every other business out there.

If this were not so, capitalism has broken.  A company can have a competitive advantage, but without a "moat" these advantages are not durable.

I'm not really a competent enough investor to accurately calculate replacement cost, though.  But by going over the balance sheet carefully, I can modify the P/B to get something I think is a rough approximation.

And that would explain why reinsurers stay around a P/B of 1.  Most of their replacement cost is just in the bonds they are required to hold.

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#15) On April 27, 2012 at 7:51 AM, Valyooo (99.82) wrote:

Yeah that's basic economic law but it doesn't seem to ever hold true which is why Aapl is killing the competition and KO has been around forever and PEP still can't touch it 

 

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