I recently read a Motley Fool article about book value, and I decided to follow up on this line of thought to show how to use book value in investing decisions.
By definition, book value is total assets minus liabilities, or net worth. To calculate your personal book value, add up your total assets (your house, car, furniture, and all other potentially eBay-able items) and subtract all of your liabilities (credit card debt, mortgage, and other debts). This is your book value, which basically measures your net worth if you died today and bequeathed all of your worldly possessions.
A company's total intrinsic value can be stated as economic book value plus the present value of future free cash flows. Today we'll ignore free cash flow to focus on the first part -- book value. The first task would be to mark assets and liabilities to market.
Marking to market
Book value often fails to reflect current economic reality because of accounting quirks. For example, accounting rules often state that assets be valued at the lower of cost or market, meaning the lower of market value or whatever you paid. If a publicly traded company had outbid the U.S. government by half a million dollars for the Louisiana Purchase, that company would now own 22.3% of the land in the entire United States -- yet that land would be carried on its books at its $15.5 million purchase price, rather than its true value, which would be trillions and trillions of dollars. St. Joe's (NYSE: JOE ) is an example of a company whose assets are not marked to market. St. Joe's owns more than 800,000 acres of land in Florida, much of which was bought decades ago for dollars per acre. Obviously, this land is worth much, much more now and must be adjusted to current market value to get an accurate reflection of true book value.
So the first step would be to mark all assets and liabilities to market, in order to make book value accurately reflect current economics.
Tangible assets are those that can be touched and measured -- for example, cash in the bank, inventory, or a factory. Intangible assets are those that can't be measured. The most common intangible asset is goodwill. Athletes are often described as having intangibles, such as leadership, toughness, and vision. While these are good qualities to have, they can't be valued, nor can you sell them, so they must be removed from the calculation. This leaves us with tangible book value (tangible assets, liabilities). Tangible book value is a rough estimate of what a company would be worth if it was liquidated.
Valuing tangible book value
Now we get to the meat of the discussion: What does tangible book value actually mean? Unfortunately, there's no simple answer, because tangible book value means different things to different companies. The key question to ask is whether the company is balance sheet-driven or not.
No tangible assets needed
Let's pretend I somehow become a celebrity. Celebrities make money because of intangible factors -- fame, good looks, acting skills, etc. Thus, as a celebrity, my current assets and debts (net worth) would have no bearing on my future earnings. My intangible skills would allow me to earn money from making movies, book deals, and TV shows regardless of whether I have $1 million in the bank or $1,000. In the previous Fool article on book value, Microsoft (Nasdaq: MSFT ) was used as an example of a company whose earnings are driven by its intangible assets. Microsoft, like the celebrity, is not balance sheet-driven, and thus tangible book value is of little use in valuing these types of companies.
So what kind of companies ARE balance sheet-driven? Suppose that, instead of becoming a celebrity, I decide to become a gambler. As a gambler, I need capital to bet, so my net worth is critical in trying to forecast my future earnings. For example, if I have $10 million in net worth, I can make a lot more money gambling than if I have $100,000 to work with. In this case, intrinsic value is closely tied to tangible book value.
What kinds of companies fit this profile? Most financial service companies -- such as banks, insurance companies, and mortgage lenders -- whose assets can be converted to cash, as well as homebuilders, are generally valued based at a multiple of tangible book value. After all, financial institutions such as Bank of America (NYSE: BAC ) and American Express (NYSE: AXP ) make money by betting on the interest rate spread between their tangible, interest-earning assets and the cost of their interest-bearing liabilities. Homebuilders such as Pulte (NYSE: PHM ) make money by betting on the spread between future home sales prices and land and residential development costs. These companies are balance sheet-driven because they use tangible assets to make money.
While it's always great to buy companies at or below their tangible net worth, it's also important to make sure tangible book value isn't going to shrink. If a company has a history of losing money, or has skeletons in the closet such as litigation issues or, for insurance companies, hurricane loss exposure, then tangible book value is likely to erode as assets are disposed to pay off losses. Furthermore, if a company has a poor history of capital allocation, then tangible book value is likely to decrease. Many mergers, such as Time Warner's (NYSE: TWX ) purchase of AOL, are examples of value-destroying mergers (although in this case, it was primarily intangible, rather than tangible, assets that were eroded).
Using book value in investment decisions
So to simplify, when calculating book value, tangible assets and liabilities should be revalued to current market values. Then investors should decide whether the company's future earnings depend on its tangible assets or not. If the company's main assets are intangibles, such as Coca-Cola (NYSE: KO ) or Disney's (NYSE: DIS ) brand, then tangible book value has little bearing on intrinsic value (assuming the company isn't going to go bankrupt). If the company's future earnings are balance sheet-driven, as is the case with many financial institutions, then investors should view tangible book as a rough estimate of liquidation value, and try to pay close to, or below, tangible book value in order to limit downside risk. Early in his career, Warren Buffett bought Illinois National Bank, which by many measures was one of the best and most profitable banks in the nation, at less than book value. Buying good companies at or below tangible book value limits downside risk and provides a margin of safety.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.