Is book value meaningless?

In Warren Buffett and the Interpretation of Financial Statements, the price to book ratio is not presented as a particularly useful metric for investors.  But studies show that stocks with low price to book values, when held for a long period of time, will outperform the market.  Who is right, the academics, or the billionaires?

Even though Warren Buffett (and his mentor, Benjamin Graham) had some early success buying stocks at a fraction of their underlying asset value, both investors, and particularly Buffett, focused more on acquiring stocks at a discount to earnings.

There are three big problems with book value:

  1. Undervalued assets, by definition, are not valuable to the average investor.
  2. Intangible assets aren’t factored into the price to book value.
  3. Without mark to market accounting, the pricing of tangible assets is always questionable.

For the first problem, imagine you found out that an energy company with negative earnings is selling at $1 a share and owns a pipeline valued at $2 a share.  If you were a major investor like Graham or Buffett, you could buy enough of the company to get a seat on the board, and then you could force the company to liquidate.  If you’re a regular investor, though, that option isn’t at your disposal, and the management team may decide that they’d rather keep their jobs and run the company into the ground, rather than do the right thing for investors.

To illustrate the last two problems, let’s look at a couple of extreme examples;

Extreme example #1: Billy’s Coke machine

Billy is good friends with farmer Joe and Buddy, a beverage distributor.  Through these two contacts, Billy was able to set up a Coke machine at farmer Joe’s roadside market.  Farmer Joe covers the cost of electric for the machine, and he allows Billy to park the Coke machine on his property in exchange for a free weekly case of Coke.  Buddy charges Billy market rate for the all the Cokes (including farmer Joe’s case) but, because he’s a friend, he’s able to get the best bulk discount offered by the distributor.

What are Billy’s assets?  His most important assets are his relationships with Joe and Buddy, because they both allow him to operate a profitable business in a stable and secure marketplace.  However, neither of these relationships can go on the balance sheet, because they’re not tangible assets.  The only tangible asset Billy has is his old Coke machine, which he bought 10 years ago.  If he were using mark to market accounting, that Coke machine would be held on the books at its replacement value, which might be a thousand dollars if it’s in good working condition.  It is far more likely, though, that Billy is marking the machine at its original cost minus depreciation which, in this case, is $0.  In other words, Billy has no assets on his books.  As long as he’s selling enough Cokes to cover his costs, his price to book is infinite.

Extreme example #2: General Motors

In 2004, General Motors had $27 billion in net assets.  Less than a year later, they had spent down their net assets to zero, and now, after 4 more years of negative earnings, GM is more than $86 billion in the hole.  In 2004, GM would have been a bad buy at any price, even though it had positive net book value.

Book value is rarely helpful

For companies like Billy’s Coke machine, an investor might be scared off an otherwise good investment because of a high price to book value.  For companies like GM, a low price to book might lead an investor to toss money into a black hole.  In both cases, price to book is misleading.

But might it also be damaging?  I recently did a regression analysis of more than 3,000 stocks and found that the price-to-book ratio is positively correlated to Return on Assets, with a t-stat of 13.  In other words, when you pick a group of stocks with low price-to-book values, as sure as the sky is blue, that group will have a lower than average return on assets.  If you buy one of those companies, you’ll essentially be purchasing assets that are discounted because management doesn’t know how to make use of them.

So when is book value helpful to the average investor?

As I stated earlier, economists have demonstrated that low price-to-book stocks will, over time, outperform the market.  But they have also demonstrated that low price to earnings stocks will outperform the market.  PE and the Price to Book ratio apparently serve the same purpose (and may be redundant metrics in a screen).  Price to Book is just a blunter instrument.