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August 17, 1998

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Subject: Book Value
Author: AngryCandy

A couple times now I've disparaged the use of book value as a valuation tool when applied blindly to all companies and to the market as a whole. I thought I'd back that up.

As I've said before, book value is a random, arbitrary value.

To quote from Peter Lynch's One Up On Wall Street:

  • ...book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin.
  • ...When you buy a stock for its book value, you have to have a detailed understanding of what those values really are.
  • Just as often as book value overstates true worth, it can understate true worth. This is where you get the greatest asset plays.
  • Companies that own natural resources - such as land, timber, oil or precious metals - carry those assets on their book at a fraction of the true value...
  • ...There are many kinds of hidden assets besides gold and silver. Brand names such as Coca-Cola or Robitussin have tremendous value that isn't reflected on the books. So do pateneted drugs, cable franchises, TV and radio stations - all are carried at original cost, then depreciated from the asset side of the balance sheet...
  • ...The accounting methods for "goodwill" were changed after the 1960s when many companies vastly overstated their assets. Now it's the other way around...
  • ...Under the current rules of accounting, Coca-Cola Enterprises has to 'write' this goodwill down to zero over the next four decades, while in reality the value of the franchises is rising by the year... Not only is Coca-Cola Enterprises doing considerably better than it would appear on paper, but every day the hidden asset is growing larger.
  • There's also hidden value in owning a drug that nobody else can make for seventeen years... On the books, those wonderful drug patents may be worth zippo.

I'll stop there but I I'd like to highlight several points.

First of all, clearly, the "book value" as called up on a screen or as listed on a balance sheet can have little or no bearing on any real-world value.

Second, companies today dramatically UNDERstate assets rather than overstate them. There have been fundamental changes in the accounting rules regarding book value that make comparisons to older markets suspect.

Third, companies like Microsoft or Cisco or Coke or Gillette or many hundreds of other have tremendous asset value that will NEVER be shown on the books by merit of their brand name and their powerful marketing machines.

Fourth, (this is my point, not Lynch's) as our market becomes more heavily weighted to high-tech, information-age companies and less weighted in heavy industrials, OBVIOUSLY the book value of the "market as a whole" is going to go up. Microsoft, Dell, etc. simply cannot be measured the same way you measure Bethlehem Steel or Citicorp or Barrick Gold. Over the last 15 years, many hundreds of billions of dollars of market cap have been created in companies that didn't EXIST before. MSFT at $300 billion, CSCO at $100 billion, DELL at $70 billion. These are brand new companies.

PC stocks, software stocks and now even Internet stocks - these entire industries just plain old didn't exist before. They have changed the world and the stock market in very fundamental ways. I'm not saying that means they aren't still grossly overvalued - they might be, I don't know - but I do know you aren't going to get anywhere trying to shove a square peg into a round hole.

Comparing the book value of the "market as a whole" when the market consists largely of PC and software stocks to the book value of the "market as a whole" when it consists largely of steel, railroad and other heavy industrial companies just doesn't make any sense.

I have more to say but I doubt many people made it down this far. Hope this was of some interest.

-chris


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