Is Price/Book Useful?

28 03 2010

I was watching Warren Buffett on CNBC’s Squawk Box during spring break (you can see I had a very exciting vacation), and one of the audience members asked Warren a question about stocks with a low price to book value. The questioner stated that a certain bank (was it citi?) couldn’t go any lower because its price/book was nearly one. Never mind the fact that a price/book ratio for something as complicated as the balance sheets of large banks is nearly meaningless at this point (who knows what assets are actually worth something!), Warren responded that the price/book statistic doesn’t even mean anything (or something to that extent).

I’ve found that many value investors rely heavily on the equity of a company in their valuation of it. The main valuation technique (and supposedly the most reliable) in Bruce Greenwald’s book, “Value Investing: From Graham to Buffett and Beyond,” centers around adjusting the balance sheet to reflect the equity of the company if it were sold off today. Keep in mind that this book is a textbook for the Ben Graham Centre for Value Investing’s workshop and that Greenwald has been referred to as a guru for Wall Street gurus by the New York Times. To most investors, buying a company for less than its equity seems like a fool proof way of getting a deal. This is actually not the case.

As stated in a previous post, the value of a company is the cash that the company produces discounted back to present value. Let’s consider the case of a company who’s just breaking even–not making or losing any cash. Let’s say our fictional company has $100 million in assets (adjusted for actual resale value) and $50 million in liabilities leaving it with $50 million in owner’s equity. As a direct purchaser of this entire business, how much would you be willing to pay?

Of course, selling off the assets takes time. For simplicity, let’s say it takes 1 year to actually sell off the assets/pay the liabilities and get your $50 million. Discounted at 9%, that $50 million in one year is really only worth $45 million to us today. After we take into consideration the actual labor involved in coordinating a break up, we may be willing to only pay $40 million. Thus, $50 million dollars in equity is only worth $40 million dollars to us. Now, since most of us aren’t going to be able to buy a company of this size in its entirety, we’ll have to look at this scenario from a shareholder’s perspective.

It could very well be the case that management is going to continue to employ its 50 million in equity for another 5-6 years without turning a profit. Since we are only shareholders, we don’t have the ability to break the company up now. Thus, we’d get our $50 million in 6-7 years. Discounting this back to present value, the equity is only worth $25.8-$23.5  million to us today. In the case of a company who’s using up cash, there is the case that management ends up decreasing the assets leading to less equity when the company finally breaks up. It’s also possible that our fictional company makes a steady profit, but one that is tiny compared to its equity. This would also justify a valuation below book value. In fact, it may be worse that the company consistently turns a profit because this may blind investors to the idea that the company should be broken up and its equity distributed to owners who can employ it at a higher rate of return.

This may be a fictional example, but its principles apply to real businesses. Such scenarios would completely justify a price/book of less than one.

So how could Graham’s Net-Nets be profitable? First of all, a lot of them aren’t. Graham would greatly diversify his holdings of Net-Nets because they often went south. The situations in which it was profitable were more than likely due to the fact that a company which qualifies for a Net-Net is so far below its liquidation value, that there is enormous incentive for the owners to liquidate it. The market usually catches on to this and drives the price back up. Or, the company is liquidated in the future, and Graham bought it at a large enough discount that he makes a profit anyways.

Because of all of these reasons, I don’t think that the price/book value of a company is a worthwhile stat. And I certainly wouldn’t base my entire valuation of a company on its book value. I tend to see the balance sheet as an indicator of the company’s ability to continue operations without fear of bankruptcy. Buying companies with low price/book values is a strategy that may produce a few good buys, but mostly just leave you owning a lot of crappy businesses.

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