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Valyooo (99.82)

Where does book value fit part 2

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May 02, 2012 – Comments (5)

I just wanted to add Another quick thought I had to my previous blog about where book value it's into the equation
If you just care about earnings and not book value, imagine u had a company with no growth. You probably wouldn't buy this company but bare with me. They have a book value of 10, earnings of 2 a year, and a price of 20. If they never pay a dividend and instead retain earnings, in order to maintain a constant p/e of 10, the stock will never go higher If you don't factor I book value because they will always earn 2. After 500 years they've earned 1000 in cash. You're going to tell me the company is still worth the same thing it was before it had 1000 per share of retained earnings, as it was after it retained all those earnings? Impossible. I just don't really know where to fit it in to the equation
Also conversely, does p/e matter at all for banks, or only book value?

5 Comments – Post Your Own

#1) On May 02, 2012 at 11:03 AM, somrh (91.33) wrote:

I think this is where EV/earnings (EV/EBIT, EV/FCF, etc) would probably be more insightful. In this case, market cap ought to increase at the same amount as cash increased to maintain the same EV multiple. I like the EV multiples because it gives you a nice way to take into account both cash and leverage a company uses with one simple multiple. 

But there is one other factor I would consider. When the company retains earnings and sticks it into a lousy interest bearing account that, at best, keeps up with inflation (and possibly worse) then I would want to discount that. A dollar today (paid as a dividend) is worth more to me than a dollar tied up in a stock that I have no access to. If they're retaining it becaues there is a good investment opportunity on the horizon that's a different story of course.

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#2) On May 02, 2012 at 12:09 PM, ElCid16 (93.29) wrote:

Even in this case, I still wouldn't look at Book Value.  But this doesn't mean I'd neglect all items of the balance sheet, namely the cash hoard that the company would have...

I agree with the first comment.  If you value a company using EV instead of market equity (P/E), you'd capture this if your valuation.

Maybe the point of your blog is just to say that you shouldn't just use P/E...I fully agree.

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#3) On May 02, 2012 at 12:33 PM, Valyooo (99.82) wrote:

Not exactly what I am trying to say...cuz I pretty much only use PEG for price (I use a lot else for evaluating the company).  I look at margins, revenue, growth, sector, chart, macro, earnings, etc.  But then when I look at the price to justify it, I only use PEG.  If its a bad company I will not buy it or I will buy if the PEG is super low.  Good company I pay up.

But, in the example in this blog, it is basically like saying if you DONT use book value, any and all earnings this company makes are worth absolutely nothing unless it is paid out as a dividend, right?

 However if a company had a book value of basically nothing and the earnings were really good, I wouldn't care about the book value.  But if the book value didn't matter than retained earnings are worthless.  Stupid circular logic in my head that for some reason I cannnot clear up.

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#4) On May 02, 2012 at 3:08 PM, somrh (91.33) wrote:

"But, in the example in this blog, it is basically like saying if you DONT use book value, any and all earnings this company makes are worth absolutely nothing unless it is paid out as a dividend, right?"

I would say it's probably not worth anything at all anyway. You basically have a piece of paper. I think if there's enough cash, someone will come along and accumulate enough ownership to initiate a buyout or vote for policies that put the cash in shareholders' pockets.

But even then there are complictions. For example, does the stock have classes of shares that would prevent non-insiders to make decisions against the wishes of insiders who may not want to distribute the cash? 

I actually don't like book value too much any more to be honest. In some cases it's going to overvalue the assets (in the case of liquidation, for example, you may get quite less than book value.) But if the assets are producing solid cash flows, I think the assets can be worth far in excess of book value.

I figure any asset is either worth (1) the amount of money I receive if I liquidate it for cash (market value) or (2) the present value of the cash flows I can generate from it. Book value rarely reflects either of these figures.

I do think the cash that the company in your example has a value and shouldn't be ignored. So the assets include both the cash flow generating assets and the cash (or the value of whatever the cash is invested in.) To put this in the EV context: 

Market Cap = EV (cash flow generating assets) + Cash (liquidation value of non-operating assets) - Debt

I think for your example, I wouldn't invest in it unless I had some belief that there would be some catalyst (say some activist hedge funds that arranged to put that cash to good use or were looking to buyout the firm to control all of the cash flows). If it had a goofy share structure that would prevent such a scenario, I probably wouldn't touch it at all.

Without dividends, the stock is just a piece of paper in my opinion which has a market price some other fool is willing to pay for it. 

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#5) On May 02, 2012 at 4:41 PM, Valyooo (99.82) wrote:

I just realized something funny.  Megashort in my last blog said he doesnt care about book value...yet he hates ETF's and CEF's trading over NAV.

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