Occasionally I will write about some basics of value investing and in the process highlight and illuminate some of the basic stock market terms. key principles as well as give an idea of how I use these indicators or ideas in my own stock selection .

What is Book Value?

The way to identify an undervalued stock is to empirically determine an intrinsic value of the stock that serves as a benchmark against which the stock price can be compared. If this intrinsic value is higher than the stock price in the market today, than the stock can be considered undervalued and vice versa. Over the years, many methods of establishing this valuation benchmarks have been devised and are in use today. Book Value of a stock is one such method.

Simply put, the book value of a stock is the value of its total assets less total liabilities.

If you look up any balance sheet you will find that it is divided in 3 sections: Assets, Liabilities and Shareholders Equity. Since Asset  minus Liability always equals Equity. getting the book value of the stock is as simple as reading off the value on the Total Equity line.

Why Use Book Value as a Valuation Method?

Book Value, in an ideal world, represents the value of the business the shareholders will be left with if all the assets are sold for cash and all debt is paid off today. It is therefore a much more conservative way of valuing a company than using earnings based model where one needs to estimate future earnings and growth. Earnings estimations are always wrong as they are essentially guess work (there may be exceptions in well regulated utilities markets where prices are regulated and earnings growth is highly correlated to population growth which can be modeled with a high degree of confidence). There are too many variables that influence earnings, and one has no way of accounting for these variables in the future when making these projections.

Working with Book Value is more firmly grounded in today’s reality. In this case, we are not at all concerned about earnings growth and profitability of the company. All we care about is whether we are able to buy the business for less than what its assets are worth (after accounting for liabilities). This is commonly expressed as the ratio of Price to Book. In this case, we are looking for a P/B ratio of less than 1. After all, if we are able to do this, we can quickly turn around and sell these assets in the market one by one and realize a quick profit.

However, in reality, one needs to exercise caution when using a simple Book Value to evaluate a stock.

Book Value is Not Always What it Seems

It is important to realize that the book value that is reported on the balance sheet is an accounting number and as such it may or may not be the same as the true market value of equity sitting on the company’s books.

For example, care must be taken when ascribing value to the long lived assets such as plant, property including real estate and equipment. Accounting requirements do require that most of these assets (except real estate) be depreciated at a pre-determined rate. The expectation is that depreciating assets at their specific schedules makes their book values close to the market value as it is based on the historical wear and tear of the assets in question. But this is not always true. For example, a plant may still be using equipment that is decades old and has been fully depreciated but clearly has some economic value. I have personally seen examples of this in some old line manufacturing industries. Granted that this equipment may not be worth much more than scrap value in the market place but that is also not always true.

Real estate presents another challenge. They are typically not marked to the market and are carried at their historical valuations on the balance sheet. Consider a company that owns 100s of thousands of acres of real estate in Florida, at an average booked cost of $2000/acre. This company is now developing retirement resorts and communities on this real estate. Clearly the value of the real estate is enhanced by the use that it is being put to but if you just go by the book value on the balance sheet, you will miss this important point.

(Yes, there is a company like this doing just that)

Inventory Can be Simple or Complicated

Inventory, if it turns fast enough, is typically not a problem. However, depending on the accounting method the company uses to value inventory, its value may be off quite a bit from its true market value. If the company uses a LIFO method (Last in First out) of inventory valuation, in a rising price environment the company will be expensing more than it is truly using and hence the inventory on the books may be under reported. Reverse is true for falling price environment (for example in semi-conductors and other high tech industries). One can construct similar arguments for the FIFO method of valuing inventory.

When I was running my own manufacturing company, this mismatch became quiet clear to me as even though our inventory overall turned pretty well, not all segments of the inventory did. There were quite a few types of inventory that moved really slow and they always tripped us up when we sat down for product planning or strategy sessions. It always pays to look deeper in the inventory line item, just to make sure that you are not surprised later.

Intangibles

A company, if it has been operating for a while, has other assets that are intangible. Some of these intangibles are reported on the balance sheet. For example, Goodwill, or as it is sometimes called, Cost in Excess, is the amount this company has overpaid in the past for acquisitions. This value is amortized, but as a potential investor looking to buy stocks. you need to ask if the Goodwill that remains on the balance sheet is really worth what is says it is. Did the company actually receive additional value from these acquisitions that is really worth this amount? Some such sources of value could be a Patent portfolio. customer lists, brand value, etc. Typically, a major part of goodwill is just fluff as companies end up over paying for acquisitions as they are not objective judges of value :-). If there is really some value in the goodwill, than that needs to be reflected in a better profit margins for the company.

The company itself may own sources of value that are intangible and are not represented on the balance sheet. It is not on the balance sheet as the market has not yet ascribed value to these assets, such as through acquisitions or other similar transactions. For example, a company like Google or Microsoft have great intangible value in the quality of their employees as well as their dominant positions in their markets. A good value investor will not skim over these sources of value and will try to ascribe reasonable valuations to them.

Classic Value Investing Tries to Side Step Some of These Uncertainties

As you can imagine, proper analysis of the balance sheet requires quite a bit of work. One way to avoid this is to find stocks where this level of detailed work is unnecessary to establish its value. Net Tangible Book Value and Net Current Asset Value are two such measures that to one degree or other simplify the balance sheet valuation process.

Net Tangible Book Value. Here, we take the book value of a company and subtract the intangible asset value, counting them for nothing. If a company is still undervalued, than it is most likely a great buy.

Net Current Asset Value (NCAV): This goes one step further and removes the Long Term Assets from the Net Tangible Book Value. What you have left over now is just the Current Assets (assets that are either cash or can be quickly converted to cash) less Total Liability. If the resulting value is higher than the market value of the company, this stock is a definite buy. These cases are rare but do exist.

I lean towards balance sheet valuation and most stock picks you will find in the premium section are based on this. However, there are situations where this kind of valuation may not reveal good stock candidates and one needs to look to the earnings for finding undervalued stocks. In one of the future articles I will write about how to use earnings to estimate intrinsic value of a stock.