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Book value is a tool to properly evaluate a stock
The shareholders’ equity section of the balance sheet
is one of the most informative yet least understood portions of the balance
sheet. Many investors don’t realize that shareholders’ equity is also
referred to as book value. When reviewing a balance sheet, start by
understanding the book value, both per share, as well as absolute. Always
compare book value per share with the current share price, to get a quick
appreciation of the premium or discount from the accounting value one is
paying or receiving for the stock. This is a good initial way to start
focusing on what is a reasonable entry price for a stock. Currently (March
2007), the S&P 500 companies sell for approximately 3.1 times book value.
The author, however, looks for companies selling at or below book value.
Dissecting
book value is important. By subtracting, from total book value, intangible
assets like goodwill and prepaid expenses, investors can gain an
understanding of the accounting value of the hard assets that support book
value. This is called “tangible net worth;” while it’s not market value, it
is a good benchmark figure.
Start thinking in terms of what is the amount of
“air” that you as an investor are willing to pay for. The difference between
the market capitalization of a company and its tangible net worth is the
amount of “air” in a stock. One can easily convert it to a per share figure.
Market capitalization represents the amount of shares a company has
outstanding, times its share price. Investors need to decide if the
company’s cash flow or potential cash flow is sufficient to both cover the
equity and “air” in the stock, and to make an adequate return for
themselves.
Investors
can also determine, by reviewing book value, the origins of the company’s
equity. Did the company grow its book value through earnings or did it just
raise capital. The category retained earnings is there for that reason, and
represents the historical earnings of a company that management did not give
back to its shareholders as dividends. It is a positive indication if book
value was obtained through earnings, rather than just through stock sales.
While historical earnings cannot predict future earnings, they are
reflective of the pedigree of a company.
Investors also need to understand the magnitude of
(and decide if they can live with) what I call “hidden backdoor expenses.”
The professionals call these comprehensive income items. In actuality, these
are mainly expenses that bypass the P&L and are charged directly to owner’s
equity, such as minimum pension liability adjustments, deferred stock
compensation, foreign exchange translations, and unrealized gains or losses
on marketable securities and derivative instruments.
There are many companies that report positive P&L
returns, but are losing a great deal of money on these hidden recurring
expenses that are charged directly to equity. These hidden expenses can be
enormous, especially in some of the older and more established companies.
Eventually, as book value erodes, the stock price will be negatively
affected. I’m saddened by the fact that company pension plans across this
country are short funded by over a hundred billion dollars. The magnitude of
this shortfall, however, can eat away at companies’ profits forever.
Understand, when investing in these types of companies, the net income of
the company that normally belongs to the shareholders is now going to the
employees or other non-owners. As an investor, where does that leave you,
your family, and the stock price?
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