How well do you know shareholder equity?
Subtracting liabilities from assets to arrive at equity -- or book value -- is balance-sheet math that's fit for a simpleton. It really doesn't get any easier than locating the total assets and related liability lines on a financial statement. (You may as well call off the Sherpa, the St. Bernard, and the rest of the search party.)
This doesn't mean book value is an easy metric to master. Many investors mistake value as the floor, assuming that any company can simply liquidate at book value if the market ever decides it's worth less than worthless.
But assets aren't always what they claim to be worth. Want proof? Check out some of the more recent business headlines.
- E*Trade (Nasdaq: ETFC ) found a buyer for its albatross of an asset-based securities portfolio last week. As part of a capital infusion, Citadel Investment Group agreed to pay $800 million for E*Trade's $3 billion loan portfolio.
- This week, Lennar (NYSE: LEN ) unloaded 11,000 parcels of raw land and partly developed homesites, recently valued at $1.3 billion, for $525 million.
What does it mean when E*Trade is willing to take $0.27 for every buck in assets of that $3 billion portfolio? Or when Lennar will settle for $0.40 on the dollar for its impaired properties?
It means that you can't always trust book value. You can find plenty of companies trading below book value these days, especially among distressed industries like lenders or real estate developers. It's awfully tempting to pick up names you know, like Countrywide (NYSE: CFC ) and WCI Communities (NYSE: WCI ) trading for less than half of their book value.
Why not? After all, that's less than liquidation value. But hey, weren't you paying attention a few paragraphs ago? Not all shareholder equity is created equal.
Book value cuts both ways
Sure, there are times when assets are actually worth more than the value they're carrying on their books. These are called hidden assets, and value hounds like those in our Inside Value newsletter service live to unearth them.
Before the residential real estate market went belly up, how tantalizing was the story of St. Joe (NYSE: JOE ) , the paper company that grew to become the largest private landowner in the state of Florida? The company eventually wound up unlocking a good chunk of the value of its attractive panhandle property.
The rise and mostly fall of shareholder equity
In short, there are both opportunities and pitfalls in relying too much on book value. You can take book value to the bank, but only when a lot of the given company's assets are bankable. If a company's asset base consists mostly of greenbacks and short-term marketable securities, the floor will feel a lot more like a cash mattress than a sheet of thin ice.
Don't automatically dismiss the potential of an asset-rich company. Obviously, it's better to have more than less. However, if the past few months of watching respectable companies like Thornburg Mortgage (NYSE: TMA ) and Merrill Lynch (NYSE: MER ) dousing their stated asset values in white-out isn't enough to scare you from leaning on book value, I don't know what will.