The first thing beginning investors learn is that there's a difference between what a company's shares are truly worth and what their current market price happens to be. But as useful as it is to know that, it still leaves the obvious question: How do you figure out the intrinsic value of a company?
As it turns out, you can find one answer to that question with almost no effort at all. By looking solely at a company's financial statements, it's easy to gauge one useful measure of its worth. And by that measure, some stocks look more expensive than they actually are, while others aren't as cheap as they look.
Understanding book value
If you asked someone who didn't know anything about finance how much a company was worth, you'd probably get a pretty simple answer:
- What does the company own, and how much are those things worth?
- How much does the company owe?
- Look at whatever the difference is. That's how much the company should be worth.
That, in a nutshell, is the idea behind book value. The book value of a company is the value of the company's assets less the amount of its liabilities. Whatever's left presumably represents shareholder value, and that's what book value seeks to measure.
Compared with other methods of putting a value on shares, book value has some definite advantages. Many beginning investors prefer to rely solely on earnings-based valuation models. But because earnings are volatile and easy to manipulate using various accounting methods, looking only at price-to-earnings ratios can give you a distorted view of a company's value.
When book value tells a different story
That said, book value certainly isn't immune from accounting trickery. The challenge in applying book value is that what you'll find on a balance sheet doesn't always reflect the actual current value of an asset.
For instance, consider Ford (NYSE: F). The company trades at almost 20 times book value, which is much higher than rival General Motors' (NYSE: GM) multiple of 1.6 and suggests that Ford's shares are ridiculously overvalued at current prices. Yet on an earnings basis, the stock's price is just seven times its earnings over the past 12 months -- similar to GM's earnings multiple. Put another way, Ford earned almost three times its book value in the past year alone. Here, two things have had an impact on book value: Depreciating plants and equipment probably undervalue those revenue-producing assets, and widely varying debt and other liabilities have whipsawed the bottom half of the balance sheet. The company even had a negative book value for much of the past few years.
Similar problems occur for companies that rely on intangibles to generate revenue. Whether it's software companies such as Microsoft (Nasdaq: MSFT) or tax-prep provider H&R Block (NYSE: HRB), you'll often find low-P/E stocks with high price-to-book ratios. Look closer, and you'll see that in many cases, you'll find artificially low valuations on intangible assets. Lowballing the true value of intangibles prevents some accounting shenanigans, but it can make book value a dangerously unreliable indicator of intrinsic value.
The other side of the coin
At the same time, some stocks trade at low multiples to book value. Yet that doesn't automatically make them good values. For instance, right now, you'll find a wide range of financial stocks, including Hartford Financial (NYSE: HIG), AIG (NYSE: AIG), and KeyCorp (NYSE: KEY), trading well below book value. Each of them also has a reasonable attractive earnings multiple.
But the big question for investors in stocks with low price-to-book ratios is how trustworthy those book values really are. With concerns about so-called toxic assets and uncertainties about whether they're truly worth what the books show as their values, the threat of asset writedowns continues to plague some financial institutions. If a writedown occurs, then it can send price-to-book ratios soaring even if the stock price ends up falling.
One tool for your toolbox
Despite its limitations, book value is still a useful way to look at a stock. By itself, it can be just as misleading as P/E or any other indicator that looks only at a single measure of value. But as part of your integrated investing toolbox, book value is something you can use as a second check on other valuation methods. Look at book value, and sometimes, what you see will help you avoid making a huge mistake.
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