Book Value - a Real Contradiction
March 28th, 2009
Let me start this blog with a little quiz:
In the following table you have two companies that are both growing at constant rate of 5% per year. These are very Buffett style companies: stable and debt free. Everything else equal, in which one would you invest?
| Widget Inc. | Gadget Inc. | |
|---|---|---|
| P/E-ratio (price per earnings) | 10 | 10 |
| P/B-ratio (price per book value) | 5 | 0.5 |
| Growth | 5% | 5% |
If you are like most of the investors, you chose Gadget Inc.. Price per earnings is the same, but the other valuation metric, price per book, shows that Gadget Inc. is cheaper. This is what Ben Graham is teaching us in The Intelligent Investor and in Security Analysis. This is also what he taught to Warren Buffett. Basically you will get what the company owns for 50% of its value. In the case of Widget Inc. you would pay 5 times what the company owns.
Let’s assume that the stock price for both companies is $10 which means that the earnings are $1 per share. The book value for Widget Inc. is $2 per share (P/B = $10/2$ = 5) and for Gadget Inc. $20 per share (P/B = $10/20$ = 0.5).
Now we can calculate the return on equity for both of the companies:
- Widget Inc: ROE = Earnings/Book Value = $1/$2 = 50%
- Gadget Inc: ROE = $1/$20 = 5%
So for every dollar invested into the business (machines, working capital etc.) Widget Inc. can generate 50 cents of earnings (50% of one dollar). Gadget Inc. will generate only 5 cents for each dollar. To grow 5% a year, which means that the earnings will grow 5 cents next year, Gadget Inc. needs to invest $1 into the business. Widget Inc. has much higher returns, so it needs to invest only 10 cents.
What this means, is that Gadget Inc. needs to invest 100% of its earnings to grow 5% a year. Widget Inc. can grow 5% a year by investing only 10% of its earnings and it can pay the remaining 90c as a dividend (9% dividend yield at the price of $10). If Gadget Inc. will keep growing and does not change its strategy, they can never pay a dividend.
Gadget Inc. works basically like a bank account with 5% interest rate with one very important difference: you can never withdraw you funds because those are needed to growth the company. The stock investors in average expect about 10% annual return, so when Gadget Inc. reinvests it’s earnings at 5% rate, they are actually destroying value.
When you are comparing different investments in general, you are naturally thinking in terms of returns you will earn. Your thinking regarding the book value of the company (i.e. the assets the company owns minus its liabilities) should not be any different; the more the assets are earning, the more you should be willing to pay. You don’t want to pay the same amount for an asset that earns 5% than for an asset that earns 50%.
Based on the information above, Widget Inc. with its higher P/B-ratio and ROE is clearly a better investment. So why would have Ben Graham - and early Buffett for that matter – chosen Gadget Inc.? Why did Graham consider the premium paid over the book value to be speculation? I think there is couple of reasons:
- Graham thought estimations of future earnings to be very uncertain
- Unlike earnings, the book value could be estimated with some certainty
- The thinking was that the company could liquidate itself and distribute the proceeds to the shareholders if its price is much below its book value. So there was margin of safety in that kind of situations.
Later on, Buffett changed his strategy and wrote, “Ben Graham wanted everything to be a quantitative bargain. I want it to be a quantitative bargain in terms of future streams of cash.” So Graham did not want to rely on the future earnings, but preferred to base his valuation on what the company owned.
Buffett confirms this difference in his speech to Stanford Law School students in 1990:
The strange thing – it’s a real contradiction – is that if a business is earning a given amount of a money and everything else is equal, the less it has in assets, the more it’s worth. You won’t get that in any accounting book.
To be fair, Graham would have probably picked the right company, if he had been told that the future earnings are 100% secure.
This same example also illustrates how good of a valuation tool the P/E-ratio is; Widget and Gadget both had the same ratio. Please also note that they have also the same PEG-ratio.
Think about all the investing books and guides you have read where the valuation is based on the above mentioned ratios. Think about all the investing services that faithfully report these ratios year after year. Return on equity (or return on invested capital for companies with debt) seems to be the missing link in the popular investing literature. Maybe we should be happy about that, because that implies that there is some hope for intelligent investors after all!
Comments are welcome.
Really interesting stuff.
Now that you have told me what not to do, I hope you will also tell me what I should do.
Great article! This is an interesting way to illustrate the importance of investment returns. I think another thing that people miss (or forget) when they talk about Graham is that he came from a very industrial heavy era. Railroads, manufacturing, etc. The book value is very important aspect of the physical value of the company. In many of today’s industries - think software, consulting and finance - companies are much more “asset light” which makes analysis much different from his original theories.
Thanks for the thoughts,
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That was very interesting. I have just been reading the intelligent investor, so i can resonate with your thoughts.