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Book value vs book value growth considerations


KinAlberta
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Book value is always thrown out there as a measure of value yet so much can affect a book value I thought I'd see what people think of it as a measure, its strengths, weaknesses, etc.

 

Too me the rate of book value growth should be a better indicator but is it?  Maybe not for cigar butt investing.

 

Anyway, everyone's thoughts please.

 

 

 

Some articles (based on AAII research)...

 

The Importance of Book Value

by Charles Rotblut, CFA

http://www.aaii.com/journal/article/the-importance-of-book-value?adv=yes

 

FINDING THE WINNERS AMONG LOW PRICE-TO-BOOK-VALUE STOCKS

By John Bajkowski

http://www.aaii.com/journal/article/finding-the-winners-among-low-price-to-book-value-stocks

 

 

 

And coincidentally a what worked article that just seems to have been published today... (I was looking for an AAII article published last June)

 

Does Complexity Imply Value? AAII Value Strategies From 1963 To 2013

Posted By: VW StaffPosted date: February 27, 2015

http://www.valuewalk.com/2015/02/does-complexity-imply-value-aaii-value-strategies-from-1963-to-2013/

 

http://www.alphaarchitect.com/blog/2014/10/20/backtesting-13-aaii-value-strategies-what-wins/

 

April, 2007

 

IT'S HARD TO BEAT LOW PRICE-TO-BOOK

by LARRY

http://www.austinbug.com/larvaluebug/archinvest4-07.html

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I think that the value of a stock comes from 2 things listed in order of importance

 

1.the future cash flows discounted at a reasonable rate. I think this accounts for 80% of the value of a stock

2.the tangible value of it's assets aka book value. about 20%

 

Let's look at few companies with respect to earnings and book value

A. AAPL- price to book of 6. This means you are paying 6 times for the assets of the company. If apple only owned one chair and one desk for a cost of $100, you are paying $600 for the entire company.

B. PBR- Price to book of .36. This means you are paying 36 cents on the dollar for all of it's assets like rigs, property plant and equipment.

 

Now with respect to future cash flows of apple and petrobras, i think we would all agree that apple has a brighter future than petrobras. Apple has pricing power, high margins, and good management. Petrobras sells a commodity product, has management that might be stealing from company funds, and low margins.

 

Just using the two to show how future cash flows should be the major thing that people look as opposed to price to book. Let me know what you guys think.

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In accounting everything is tied together.  If you have a company that generates free cash flow and doesn't pay it out as a dividend then book value grows. 

 

I like book value for a few reasons.  It changes at a much slower rate compared to earnings.  If a company hasn't grown book value for years then you have insight into their lack of earning power.  If a company is growing book value you know they're growing earnings.  Book value is widely used in private market transactions, if it's an important metric for private sales and we're saying that public values should eventually approximate what intelligent private buyers would pay we should consider the value.

 

Book value is an estimate, but earnings are as well.  Cash flow supposedly isn't, but there are ways to modify it too.  I like to buy companies with great earnings at low multiples, but earnings can be a mirage at times.  What if Apple's products suddenly are found to cause cancer and they fall off a cliff.  A 10 year extrapolation doesn't cover that.  But book value is more tangible, even with estimates.  If earnings suddenly falter you are still buying something, even if it's worthless office chairs and cash in a bank, it's something.

 

Neither is a silver bullet, but they are very connected.  To look at one metric and forget about the rest is to ignore some of the facets of an investment.

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^^ Future cash flows is all that matters (for long term holders) - predicting them is the tough part.  So I'd say it depends on the cash flow generating nature of the assets and their combined longevity plus  the people, the brand, etc. 

 

Software employees don't get valued as capital assets but are treated as expenses and the patents, 'branding', etc. if successful have very high market high value for a while.  On more commodity based products like electricity from a power plant the book value is likely more meaningful - high capital, low labour. Replacement cost might be even more meaningful in terms of a going concern consideration.  Inputs, say coal reserves for a power plant might be valued at some very low historic cost and ownership as an asset might enhance cash flows going forward. (Solar plant gets its fuel for free - not even a labour expense as with software firms so that one to think about should technology improve - but then there's inventory/storage costs due to the rotation of the earth.)

 

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Price to book is just one tool in your toolbox. Sometimes it is appropriate to use it, sometimes it is not. P/B is mainly useful as a measure of valuation is commodity type businesses where the profits are earned mainly on the level of assets: so financials, commodity manufacturing, transport, etc. P/B is pretty useless for companies with heavy IP. As the poster above mentioned, AAPL's level of assets has absolutely nothing to do with its profitability.

 

P/B is quite popular with the value investing crowd from the Ben Graham days. Basically short version if P/B is low enough you will make money because a) someone will buy the company to strip it. b) P/B will revert higher (due to pricing, capacity cuts etc) because if you can't make normal profits on book then nobody will want to be in that business anymore.

 

Warren Buffett seems to be more of a P/E guy. Buying companies loaded with intangible assets that don't show up in book but affect profits.

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For me, if I make adjustments for various accountings, then I would find growth in BV useful.

 

But otherwise it can be influenced by all kinds of non-cash charges. For example under-depreciating assets, or under-reserving for insurance policies or loan defaults. These non-cash charges may not correct themselves for years, in the meantime you get inflated growth in BV.

 

My philosophy is that assets value = capitalized earnings stream. So book value and earnings power are really one in the same, and growth in BV equals growth in earnings power (or reduction in capitalization rate)

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What about the rate of book value growth as a predictor?

 

It assumes the business needs or can use invest the retained earnings at a similar rate.  Isn't the ideal business a growing royalty.  It is ideal because it needs no reinvestment or management.  Closely behind it is a business that can grow without additional capex. They both can generate high ROE.   

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What about the rate of book value growth as a predictor?

I guess I would ask - As a predictor of what?

Like all other growth measures, it's more backward looking that forward looking. It shows that business accumulated capital and at what rate. That in and of itself is not very useful. Was that capital deployed at a good rate of return or not? Will it grow at the same rate in the future? Also companies that don't pay dividends grow BV faster than companies that do. It all depends on the context.

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rate of book value growth is return on equity, it's the most important metric. If I have a giant pile of money and add a penny to it a year, I'm growing book value, nobody would be impressed, a massive misallocation of capital. I see this in many companies who should maybe leave the industry all together or close shop or do something more intelligent like trim the fat, give back the money pile - since it's not needed - or worse, it's needed and doesn't make a lot of money.

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rate of book value growth is return on equity, it's the most important metric. If I have a giant pile of money and add a penny to it a year, I'm growing book value, nobody would be impressed, a massive misallocation of capital. I see this in many companies who should maybe leave the industry all together or close shop or do something more intelligent like trim the fat, give back the money pile - since it's not needed - or worse, it's needed and doesn't make a lot of money.

I'm sure you understand this but some may not.  You have intentionally oversimplified and I agree with your points.  But just to be clear.  Rate of book value growth is a bit more than return on equity.  It is return on equity less dividends, less share repurchases, plus share issuances, +/- changes in comprehensive income, etc.  So it is important to calculate book value on a per share basis. 

 

The goal of a firm is not to increase book value.  You want to increase intrinsic value per share.  You want to generate cash flow.  You want to make money for shareholders.  You want to have each dollar of retained earnings to generate a similar or higher ROE.  The truly great business can grow without retaining earnings (increasing book value), and the incredible one can do it and shrink their equity.  That is why great businesses trade at a multiple to book value.       

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rate of book value growth is return on equity, it's the most important metric. If I have a giant pile of money and add a penny to it a year, I'm growing book value, nobody would be impressed, a massive misallocation of capital. I see this in many companies who should maybe leave the industry all together or close shop or do something more intelligent like trim the fat, give back the money pile - since it's not needed - or worse, it's needed and doesn't make a lot of money.

I'm sure you understand this but some may not.  You have intentionally oversimplified and I agree with your points.  But just to be clear.  Rate of book value growth is a bit more than return on equity.  It is return on equity less dividends, less share repurchases, plus share issuances, +/- changes in comprehensive income, etc.  So it is important to calculate book value on a per share basis. 

 

The goal of a firm is not to increase book value.  You want to increase intrinsic value per share.  You want to generate cash flow.  You want to make money for shareholders.  You want to have each dollar of retained earnings to generate a similar or higher ROE.  The truly great business can grow without retaining earnings (increasing book value), and the incredible one can do it and shrink their equity.  That is why great businesses trade at a multiple to book value.     

+1 I think Tim's reply hits the bull's eye on this!

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rate of book value growth is return on equity, it's the most important metric. If I have a giant pile of money and add a penny to it a year, I'm growing book value, nobody would be impressed, a massive misallocation of capital. I see this in many companies who should maybe leave the industry all together or close shop or do something more intelligent like trim the fat, give back the money pile - since it's not needed - or worse, it's needed and doesn't make a lot of money.

I'm sure you understand this but some may not.  You have intentionally oversimplified and I agree with your points.  But just to be clear.  Rate of book value growth is a bit more than return on equity.  It is return on equity less dividends, less share repurchases, plus share issuances, +/- changes in comprehensive income, etc.  So it is important to calculate book value on a per share basis. 

 

The goal of a firm is not to increase book value.  You want to increase intrinsic value per share.  You want to generate cash flow.  You want to make money for shareholders.  You want to have each dollar of retained earnings to generate a similar or higher ROE.  The truly great business can grow without retaining earnings (increasing book value), and the incredible one can do it and shrink their equity.  That is why great businesses trade at a multiple to book value.     

 

+1. definitely helpful, especially the part about each dollar of retained earnings generating similar or higher ROE.

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rate of book value growth is return on equity, it's the most important metric. If I have a giant pile of money and add a penny to it a year, I'm growing book value, nobody would be impressed, a massive misallocation of capital. I see this in many companies who should maybe leave the industry all together or close shop or do something more intelligent like trim the fat, give back the money pile - since it's not needed - or worse, it's needed and doesn't make a lot of money.

I'm sure you understand this but some may not.  You have intentionally oversimplified and I agree with your points.  But just to be clear.  Rate of book value growth is a bit more than return on equity.  It is return on equity less dividends, less share repurchases, plus share issuances, +/- changes in comprehensive income, etc.  So it is important to calculate book value on a per share basis. 

 

The goal of a firm is not to increase book value.  You want to increase intrinsic value per share.  You want to generate cash flow.  You want to make money for shareholders.  You want to have each dollar of retained earnings to generate a similar or higher ROE.  The truly great business can grow without retaining earnings (increasing book value), and the incredible one can do it and shrink their equity.  That is why great businesses trade at a multiple to book value.     

 

+1. definitely helpful, especially the part about each dollar of retained earnings generating similar or higher ROE.

 

 

See that's the thing.  Identifying low P/BV stocks doesn't even seem to be a good starting point for finding great businesses, just temporarily cheap businesses that may not be that good anyway.  Low P/BV seems just seems like a regression to the mean play, one requiring high turnover and generating high transaction costs/taxes and maybe high diversification (think Ben Graham).

 

Still, value investing using some pretty simple metrics seem to do pretty well.  Take some of the findings in Tweedy Brown's old study...

 

WHAT HAS WORKED IN INVESTING:

Studies of Investment Approaches and Characteristics Associated with Exceptional Returns

http://www8.gsb.columbia.edu/sites/valueinvesting/files/files/what_has_worked_all.pdf

 

So should "value investors" adopt a split personality? Aiming to have a portfolio of short term 'seasonal sale' items (good for one last puff as Buffett explained) and a portfolio of 'permanent' growth businesses? (again think Buffett and his companies).  The latter being a form of GARP investing.

 

Maybe a third (EV/EBITDAs and possible takeouts).

Analyzing Valuation Measures:

A Performance Horse-Race over the past 40 Years.

http://csinvesting.org/wp-content/uploads/2012/09/tev-to-ebitda-research.pdf

 

 

Basically, really limit one's focus on P/BV.

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The low p/b low debt/capital strategy was the best performing strategy in that tweedy browne paper if I remember right.  However, in one of his recent articles Norman Rothery mentioned a study that  showed that low p/b stocks only outperformed the market by 1% over a really long time span.

 

Ben Graham wrote an essay on this question of low p/b vs. high ROE companies.  His conclusion was for an investor to focus his attention on the middle ground of stocks with decent earnings histories and prospects and reasonable p/b ratios.  I'm sure most of you have read this essay but it is in the Intelligent Investor edition written in the early 70's.  Also in that edition in the section on comparisons of companies he would generally favor

 

I was running through a total return calculator a few months ago.  Unsurprisingly one did well holding businesses w/ high returns on equity over long periods, such as brown forman.  But the interesting thing to me is that a basket of

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