Betting on book value

Accountants versus investors

I’ve written so much about price earnings ratios on this blog, you’d be forgiven for thinking there is only one peg on which to hang an opinion on whether a company is cheap or expensive, but of course there are others.

In putting together the case for Home Retail recently, I relied on the company’s book value as well its PE, partly because it’s only been listed on the stock market for four years and so doesn’t have a long enough earnings record to compute the average of 6-10 years I favour.

Book value is the value of a company’s assets less its liabilities as recorded in its balance sheet. It’s also known as equity, net asset value or net worth.

In theory, it’s the value of everything a company and ultimately its owners or shareholders own after deducting everything it owes.

In practice book value is a very crude measure. Some companies are worth many times their book values, and some are worth less because accounting is imprecise, and most companies add value to their assets by using them to make a product or service they can sell for a profit.

There are many examples of accounting imprecision. The value of machinery is depreciated as it ages using arbitrary rates, for example, and the value of property may be recorded at its cost price or have been re-valued more recently. Intangible assets, like brands, patents, or highly efficient operations, are even harder to value and often ignored, or included at inflated values on a company’s balance sheet when it pays too much for them in a takeover.

Book value gives us a different measure to the value put on a company by investors when they buy and sell shares in the stock market. We can compare them by dividing market value by book value, a ratio known as the price to book ratio.

The market value of a successful company may be many times its book value because investors recognise it will earn big returns, which will be paid to them in dividends, or invested in new money making ventures.

The market value of a distressed company can fall below its book value because investors fear the company will be unable to profit, or stay in business. Investors in companies like this learn that book value is often illusory, as companies use up assets, like cash,  trying to turn their fortunes around, or write off the value of assets, like factories or brands, because they’re not producing the expected return.

Although buying companies whose success is recognised by investors seems like a safer bet, statistically speaking buying companies at inflated prices relative to their book values is more dangerous, and buying companies at low prices more rewarding.

An economic explanation for this counter-intuitive fact is companies earning high returns attract competition, which, in time, reduces profit and disappoints investors. Companies in trouble, on the other hand, often survive leading to increased profits and happy investors.

That doesn’t mean every share with a low price to book value is a winner and every company with a high price to book value is a loser. Some struggling companies fail, and some successful companies resist competition for decades.

Nevertheless, the shocking truth is, despite all the scandals, accountants are better at valuing companies than investors. If you indiscriminately invest in companies that are cheap according to their accountants you should do well, but only if you invest in large numbers of companies over long periods of time.

Analysing companies in more detail and employing statistics that weed out some of the weakest cheap companies, for example the F_Score or measures of indebtedness and profitability, can improve the odds.

Unlike me, UK Value Investor primarily uses book value. In fact he goes one stage further and relies on tangible book value, ignoring even the dubious value of intangible assets.

Many of the companies in the Thrifty 30 portfolio are cheap relative to their book values, though. Armour, Autologic, Dart, French Connection, Holders Technology, Johnson Service, Mallett, Quadnetics, Titon and Waterman all trade at less than book value. Unsurprisingly, the priciest share in the portfolio is high-flying XP Power. Its shares cost nearly four times book value.

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More boom and bust

OK, so accountants aren’t perfect either. The FT reports momentum behind a move to make company reports more useful for investors.

Robert Peston writes a well aimed pop at incomprehensible Basel lll banking regulations. Don’t expect an end to credit binges, and busts.

A disturbing tit-for-tat between George Monbiot and Matt Ridley. Monbiot says Ridley’s book ‘The Rational Optimist’ is full of errors. Ridley says Monbiot’s critique is. The disturbing thing is, judging by the comments, each has a cohort of followers who’ve outsourced critical thinking to these celebrity writers.

Research from South Korea shows investors use bulletin boards to confirm what they already thought they knew. It makes them worse investors.

UK Value Investor lists books that turned him on, and off, various kinds of investing.

The FT explains how high flying Connaught ran out of cash and a fund manager kicking the tyres predicted it