The Deception Of Book Value

When Benjamin Graham covered stocks, he used book value as his primary determinant in calculating value. He was well aware that when a company in distress goes on to survive, the share price of the stock can easily double, triple, or quadruple once investor certainty surrounds the pending survival. And if the company did not survive intact, the liquidated parts could sometimes still give you a positive return.

Although book value can still be a useful measurement tool in certain situation for bank and insurance companies, the usefulness of the metric has become outdated for three reasons:

#1. Companies employ far more debt today compared to the early 20th century. An industrial stock would carry one or two times its annual profits in debts back in the day, now it can range 4-8x that amount. When the business would turn, it was more common to close up shop immediately and try to salvage anything possible for shareholders.

In modern times, the ambition is to keep the company alive as long as possible, which does work out for shareholders if the company can return to profitability, but the added debt creates new creditors that have a claim on the liquidated assets ahead of the common shareholders in the event of a bankruptcy. The rise of these competing creditors were not as prevalent at the time of Graham’s writings, and limit the usefulness of modern book value calculations.

#2. The liquidated value of the purported book value in these days is much less than that of Graham’s time. If a railroad company went bankrupt in 1920, it might receive competitive bids for its routes and steel and iron supplies. You’d have a fair chance of recovering 50% to 60% of your assets through the liquidation process. As of 2014, the average bankrupt firm in the restaurant industry is able to receive 22% of liquidated value for the property that comprises “book value.”
And plus, that 22% of liquidated value is exacerbated by item #1, where you have a greater number of creditors claiming superior ownership rights to this small liquidated pie.

#3. I’m sure Charlie Munger wasn’t the first person to realize this, but he was fond of advocating that significant profits compared to minimal assets is actually a sign of a superior business because it is actually a good thing to create a whole bunch of profits while only having to put down a small amount of money into the property that creates those profits.

Imagine if someone thought about purchasing Sears stock in 2005, and saw the $110 share price against the $160 book value. You could think this presented a great deal on a stock. No. Because the company was having to spend a whole lot of money on its real estate upkeep, and the profits were not poised to grow over the long term. If profits collapse, book value can collapse in a hurry as a company takes on all sorts of liabilities to avoid bankruptcy.

What does Sears look like today? The price of the stock is $25, and the book value of the stock is $5. The company had to create a cumulative $3.8 billion in debt to stay alive up until this point in 2015, and all of those $3.8 billion in bondholders will have a superior claim to the common stockholders if a time comes to put all the property on the chopping block. This is why you should have little faith in book value–a company will take on secured bondholders when it finds trouble, and all of those bondholders will have a superior claim to the stockholders if the business ever perishes.

On the other hand, look at one of my favorite companies in the world: Hershey stock. Back in 2005, it had $5 in book value and traded at $62 per share. Benjamin Graham in the 1920s would have no interest paying 12x book value for a stock. Munger, on the other hand, would point out all the cash that could be extracted from the business: Of the $4.8 billion in sales, over $500 could be extracted from the business as dividends and buybacks without required reinvestment into property. Ten cents on every dollar of sales could go straight to shareholders without harming Hershey’s competitive position.

While Sears crumbled in the past ten years, Hershey doubled its profits and dividends. Book value had nothing to do with this–Hershey’s book value still stands at only $6.95 per share. The value of Hershey is not in the liquidated value of the chocolate factories, but rather, the unusually high amount of profit that gets produced by the relatively paltry amount of money that you have to invest in those chocolate factories.

The high book value stocks are not where the best stock market returns come from–it’s the tobacco and consumer staples that are able to charge high premiums while only deploying a small amount of cash to run the factories compared to the output received for shareholders. Pharmaceuticals are a bit tricky in that the patents themselves are highly valuable, but the actual factory cost of producing something like Tylenol is less than a nickel per pill. Oil companies are capital intensive, but the reason for outsized returns is a consequence of (1) valuation when people reinvest high dividends at low prices, and (2) the fact that profits are incredibly lucrative compared to plant investment costs once oil clears $80 per barrel or so.

I don’t treat book value as an important part of my research process (with the exception of bank and insurance stocks which are not able to dodge the first two elements as easily) because troubled companies can quickly escalate liabilities when trouble arrives, creating superior claimants for when a liquidation moment does arrive. And when the liquidation moment does arrive, a business is almost guaranteed to generate substantially below what the purported book value states. More people claiming money, and lower money received, is not an investment strategy I’d want to pursue.

And lastly, the high book value business (compared to the share price) is not the best measurement of an excellent business. Great businesses grow profits at a high rate while having low ongoing capital costs. It reasons, therefore, that producing high profits compared to low plant and factory costs would be the kind of company you’d want to own for the long haul anyway. That is why I focus on earnings per share, and the amount of profits that can be extracted without harming the competitive position, much more than I consider the book value of a stock.