This article appeared in the November 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Discover how to find high-performing companies trading below their net asset backing.
By Michael Kemp, author
The directors of Warren Buffett's US company, Berkshire Hathaway, announced in September that it would conduct an on-market buyback of its shares. The price was not specified. Instead, the company retained the discretion to pay up to a 10 per cent premium to book value. Buffett, the company's chief executive, is the world's most successful investor and because he used book value to define the price, a closer look at this metric is warranted.
Book value is taken from the balance sheet; more recently referred to as the Statement of Financial Position, and is calculated by subtracting total liabilities from total assets. It is also referred to as net assets or shareholders' equity.
Book value can also be expressed on a per share basis, calculated by dividing the book value of the company by the total number of shares on issue. This usually differs from the market price.
What book value tells you
In theory, book value should indicate what shareholders would have received had the company been wound up on the date the accounts were constructed. For this to hold true, the Statement of Financial Position should accurately reflect the value of the company's assets. However, this is rarely the case and the main reasons are
- Plant and equipment are recorded at their purchase price less an allowance for depreciation. Inflation and technological advances often render this a poor measure of current value. Book value typically undervalues the replacement cost of plant and equipment for a going concern and overvalues the sale price in the event of liquidation.
- Assets are depreciated at rates set by accounting standards. These usually differ from those established by economic reality.
- Real estate is carried at historical cost. Over time this can fall well short of its market value. The significant writedowns by Real Estate Investment Trusts (REITs) in the wake of the GFC illustrate the potential for significant overvaluations to occur as well.
- The value of intangible assets, such as goodwill, are often misrepresented in the accounts. Goodwill can be internally generated through expenditure on advertising, research and development, and years of good customer service. Alternatively, it can be acquired when one company buys another. Accounting standards require that the goodwill is treated differently under each circumstance. Internally generated goodwill is not recorded. However, purchased goodwill is recorded on the acquirer's books. The goodwill price is the amount by which the acquisition price exceeds the book value of the acquired company. Consider Coca-Cola (US), which has one of the most valuable brand names in the world. Accounting standards require that Coca-Cola does not recognise this internally generated goodwill in its books. But if Coca-Cola was acquired, the acquirer would record the goodwill as an asset- in this case around $100 billion
- For many companies, particularly those in service industries, human capital- the quality, skill and knowledge of the workforce- is of significant value. This is not reflected on the balance sheet.
Relating book value per share to market price
A favoured tool of value investors is the price-to-book, or P/B, ratio. It relates the market price to the book value. A low P/B ratio is commonly taken to indicate value, and a high P/B ratio is taken to indicate a growth share. This interpretation is simplistic and deeper analysis is recommended. The following formula is particularly useful for doing this:
P ROE - g
B = r- g
- ROE = return on equity (book value)
- g = annual growth in earnings
- r = required rate of return (cost of equity).
This shows that the underlying drivers of the P/B ratio are:
- Anticipated return on shareholders' equity
- Required rate of return
- Anticipated earnings growth.
Note the use of the word "anticipated" in relation to ROE and earnings growth. The market always values shares in anticipation. In the absence of a crystal ball, market participants are heavily influenced by current circumstances in deriving future estimates. So companies that are currently achieving high earnings growth and a high ROE tend to trade on a high P/B ratio.
The investor needs to judge whether these will be maintained, because if they are not the share price is likely to fall.
What a low P/B ratio tells us
The P/B ratio is widely used in share selection. US fund manager and author, James O'Shaughnessy, found that over the long-term the market rewards companies with low P/B ratios and punishes those with high ones.
Although this might hold true for a diversified portfolio of high or low P/B shares, the discerning investor will probe more deeply when selecting individual shares. There are exceptions to any rule and it is important to realise there are a number of reasons why a company could have a low P/B ratio:
- Return on equity is low
- Growth prospects are low
- The company is in financial difficulty
- The market believes the book value is overstated in the accounts
- The share price offers good value.
Factors driving a sustained return on equity
Because the maintenance of a high ROE justifies a high P/B ratio, consideration should be given to the factors that drive ROE. It is important to note that it is the exception rather than the rule for a company to maintain a high ROE.
Dechow, Hutton and Sloan (Journal of Accounting and Economics - 1999) undertook a study covering a large sample of company data from 1976 to 1995. They found that on average, companies with initially high ROE experienced a decay rate of 38 per cent per year in the margin between their ROE and cost of equity.
Assuming a cost of equity of 10 per cent, a company with an initial ROE of 40 per cent would see this fall to less than 29 per cent in the first year and to 21 per cent in the second. This means there is a strong tendency for the ROE to move over time towards the cost of equity. Reference to the above formula shows this would see the share price fall towards its book value.
Investors are often encouraged to select companies with a high ROE but it is insufficient to make selections on this basis alone. There must be justification that the high ROE will persist. It is useful to reflect on the words of Ben Graham: "There must be plausible grounds for believing that this average or this trend is a dependable guide to the future."
The 38 per cent decay rate quoted by Dechow et al is an average and clearly varies from company to company. To assist in selecting companies capable of maintaining a high ROE, look for factors that bestow an enduring competitive advantage:
- strong market leadership
- consumer brand loyalty
- lower operating costs, or
- advantageous licensing agreements.
Where these do not exist, the barriers are low for competitors to enter that business space. Competitors will continue to be attracted as long as the anticipated ROE exceeds their required rate of return. This will result in falling revenues, reduced margins and reduced ROE.
This should not be taken as an argument against investing in companies with high ROE. On the contrary, these are the very companies that should be sought out. However, it is those characterised by enduring ROE and offered at either a cheap or fair price that will generate wealth. Companies without these qualities have the potential to destroy wealth.
- Book value (owner's equity) is calculated by subtracting total assets from total liabilities.
- The true value of a company's assets is often different from that recorded in the Statement of Financial Position.
- The experienced analyst will make adjustments to reduce these variations.
- The P/B ratio relates the market price to the book value.
- The P/B ratio is affected by market sentiment, the anticipated ROE, anticipated earnings growth and the investor's required rate of return.
- A low P/B is a good screen in the search for value but it should not be relied upon as the sole metric of shares selection.
- Look for companies with low P/B and high and enduring ROE. If ROE is low, have good grounds to believe management can turn the situation around.
About the author
Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer. Read more about Michael.
The ASX Online Shares Course is a great way to access free education about share investing. There are 11 modules to complete online, each taking about 10 minutes on average. Topics include:
- What is a share?
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