Should You Care About Book Value?

What is book value, and why should you care? If you're investing in Rule Makers, you shouldn't. Next subject.

Except�

Book value is quite useful to those who want an additional baseline from which to value a company. It also comes into play in some fairly fundamental ratios that you can put in your investor's toolbox. You can never have too many tools.

At its simplest, book value is a company's assets minus all of its liabilities. The basis behind this concept is, in broad terms, if this company were to cease operations tomorrow, sell its physical plant, its inventory, and all other property it owns and then pay off all of its debts, the amount of money left over would be distributed to shareholders. It's a pretty grim way to value a company, when you think about it. Sort of like harvesting parts from a car.

Think of book value as the least common denominator answer to the question, "What's the company worth?"

Of all the calculations that you will ever have to do, this one is the easiest. Here is the step-by-step process to determining book value:

1. Pre-calculation stretching.
   
2. Open annual report to balance sheet.
   
3. Find line marked "shareholders' equity."
   
4. Write this number down.
   
5. Go make a sandwich.
   

Did you miss it? The shareholders' equity line item is book value. After all, shareholders' equity is quantified as assets minus liabilities, right? Sure, sometimes there's some mumbo-jumbo to wade through, but for the most part, this is it.

So if we look at some Rule Maker companies, we have the following book values:

Coca-Cola (NYSE: KO)           $8.9 billion
American Express (NYSE: AXP)  $10.9 billion
Cisco (Nasdaq: CSCO)          $16.8 billion
Pfizer (NYSE: PFE)            $10.1 billion
Yahoo! (Nasdaq: YHOO)          $1.6 billion

Obviously, if we're really serious about buying Rule Maker-type companies, this is NOT the main number to use in valuing a company. Cisco is obviously worth a boatload more as an operating company than as a cannibalized scrapyard. But for people who are looking to increase their emphasis on the "Va" part of QuaVa, there is some utility here. Also, as the markets continue to plow ever downward, you can certainly look at book value to see what the lowest level your holdings could possibly go to. If you own Amazon.com (Nasdaq: AMZN), for example, your shares should not drop below the company's per-share book value of $0.07. See, isn't that reassuring?

The most familiar use of book value is a ratio, price-to-book. This ratio measures how high the share price is in relation to its shareholders' equity. Value-oriented investors in particular focus on this ratio as one of their tests of margin of safety. For example, American Express, with a price-to-book ratio of 6.16, has a lower price-to-book than any company in the Rule Maker Portfolio except T. Rowe Price (Nasdaq: TROW). This would mean that, from a book valuation perspective, AmEx would be a much more compelling buy than, say, Cisco at 23 times book, or even Coca-Cola at 12 times.

There are some limitations to book value. First and foremost, book value is a function of accounting, and is therefore not a perfect proxy to price a company's assets. Intel (Nasdaq: INTC), for example, has significant building and land assets in Santa Clara County, some of which the company has held for decades. From an accounting perspective, Intel has been depreciating these assets each year in accordance with Generally Accepted Accounting Principles (GAAP). But the book value of these assets would in fact grossly understate the true value of property and plant in the heart of Silicon Valley.

In the same vein, Intel is constantly having to update its fabs to meet changing demands in technology. Some of the state-of-the-art equipment Intel bought five years ago has a current value of pennies on the original purchase price. Still, for accounting purposes they may have several years before they are fully depreciated. In this case Intel is forced under GAAP to dramatically overstate the true market value.

So, like most numbers and investing tools, book value has as many caveats as it does advantages. Still, it is another information point for a Fool to put into his bag o' tricks for evaluating companies, even Rule Makers.

After all, even the most quality-focused Fool loves a good sale, right?

That leads us to our poll question of the day�

Is Cisco overvalued?

1. No, not when compared to Beanie Babies.
   
2. Yes, are bears Catholic?
   
3. I don't talk to strangers.
   
4. That depends. How much is Cisco worth in Dong?
   
5. Can you repeat the question?
   

Vote!

Fool on!

Bill Mann, TMF Otter on the Fool Discussion Boards

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