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UpFront/Column | May 6, 2013 | 9527 views

Putting Book Value and Price-Earnings Ratio in Perspective

Book value and PE ratio are common yardsticks to value a business. But they need to be put in perspective to arrive at a true picture
Putting Book Value and Price-Earnings Ratio in Perspective
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F

or most investors, the key to successful investing lies in reducing the complexity of the task at hand to a few easily understood principles. A common approach is to value a business by applying a few well-established ratios such as the price-earnings (PE) or price-book value (PB) ratio.

Benjamin Graham firmly believed that book value was a useful starting point to determine the intrinsic value of a business. Graham correctly assumed that shares trading at below book value could not continue to do so indefinitely. If the business was capable of remaining profitable on a sustainable basis, eventually the stock price would head north.

Yet, the diligent investor needs to exercise caution when using book value to determine intrinsic worth.

The first adjustment required is the need to value ‘intangible’ assets or goodwill. When a company makes an acquisition of a business and chooses to pay a premium to book value, the difference must be carried on the balance sheet as ‘goodwill’. Accounting rules require this ‘asset’ to be depreciated over a specified period of time. The difficulty relates to determining whether ‘goodwill’ has earning power or reflects managerial ego driven by the urge to preside over a larger empire! Graham was unequivocal in arguing that goodwill needs to be deducted from book value consistent with the view that it is at odds with a margin of safety. More often than not, the hubris that accompanies an acquisition justifies being conservative in valuing goodwill. Yet, the case to universally disregard the residual value of goodwill is clearly flawed. When an acquisition leads to either the purchase of a strong franchise, proprietary technology or a quasi-monopolistic business, the higher purchase price typically reflects the capitalised value of future ‘excess returns’. Therefore, it is vital to understand the context of a business in assessing the value of intangibles.

The need for the second adjustment arises from the accounting principle of valuing assets at historical cost or management’s perception of fair market value. The first rule in calculating liquidating value as Graham spelt out in Security Analysis is to assume that all liabilities are real but that all assets are of “questionable value”. While cash equivalents and marketable securities pose no problem, valuing assets such as inventories, receivables and plant & equipment could be somewhat trickier.

Receivables, the money due from merchandise sold on credit, should be valued at a slight discount to stated balance sheet value primarily because of the risk of non-payment as well as the time period that may elapse prior to all dues being collected. As a basic rule, the longer it takes a company to collect receivables, the greater the discount that needs to be applied.

The primary risk with inventories is obsolescence/perishability and fluctuations in market price. While fixed assets are adjusted by a ‘depreciation’ rate, the real issue relates to the ‘economic’ life versus the ‘accounting’ life of the assets. This difference can cut either way and quite often the gap can be significant. A gas transmission and distribution utility has a network of pipelines that directly define its economic earnings power. In this instance, the economic life of the assets is far longer than dictated by accounting requirements and consequently, an established franchise within a specified geographic domain has significant hidden value. Equally, if a fully depreciated plant is well maintained and reasonably efficient, the asset will be dramatically understated in terms of its value thanks to high inflation.

This article appeared in the Forbes India magazine issue of 17 May, 2013
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Comments (3)
Shivam Gupta May 14, 2013
As I understand, the importance of fairly valuing the assets on a company's balance sheet has been underscored by value investors. However, I has a couple of questions on the mode of applying the principle of adjustment:

1). Account Receivables: You state that the account receivables should be valued at a discount. I fully concur on this principle for a company that is either in a consolidating industry or a declining one. But how about a company in a growth phase? Wouldn't it be fine if we rather value these account receivables at a premium given the fact that another company who tries to create that kind of receivable balance will encounter challenges?

2). How would you judge companies that have a high dose of Cash and Investments on their balance sheets? They would be highly favored from an asset perspective but would be generating low RoCE numbers?

Look forward to your guidance on this.
Girish May 7, 2013
For any long term investment (greater than say 4-5 years) competitive edge OR MOAT needs to be checked and demanded. Ofcourse if ROCE and ROE are what as are mentioned here then there may be some MOAT here else you may not get such numbers for 10 years running. Will check the numbers and do my own analysis on this stock. Thanks for sharing the idea.
Munger Acolyte May 7, 2013
FAG trades like 600 shares a day! the impact cost alone will ensure it will be a holding for lifetime.
All great points though on P/B, P/E!
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