Book value
What is book value?
The book value of a company is generally considered its net worth; the book
value per share would be the net worth of a company divided by the number of
shares outstanding.
Benjamin Graham definitions
There is a need, in considering the book value of a company share, to know
what certain terms mean - and who better to explain them than the doyen of
investment analysis, Benjamin Graham. His definitions are:
Tangible assets: Assets
either physical or financial in character e.g. plant, inventory, cash,
receivables, investments.
Intangible assets: Assets
which are neither physical nor financial in character. Include patents,
trademarks, copyrights, franchises, good will, leaseholds and such deferred
charges as unamortized bond discount.
Graham took the view in Security
Analysis that intangible assets should not be taken into account
when calculating book value; hence, in this sense, book value per share would
be the same as net tangible assets per share (NTA) as opposed to net assets per
share (NA).
So, the assets of a company can be either tangible or intangible and, on
this point, Benjamin Graham and Warren Buffett appear to have differences in
importance.
The Benjamin Graham approach to book value
Graham clearly considered book value an important factor in assessing share
investment. He did not include intangibles in his calculations of book value
and was attracted towards companies that sold at below their book value. This
was a big factor in making a judgment about the company as an investment. He
said this:
‘It is an almost unbelievable fact that
Wall Street never asks, "How much is the business selling for?". Yet
this should be the first question in considering a stock purchase.
'If a business man were offered a 5%
interest in some concern for $10,000, his first mental process would be to
multiply the asked price by 20 and thus establish a proposed value of $200,000
for the entire undertaking. The rest of his calculation would turn about
whether the business was a "good buy" at $200,000.’
Graham did however acknowledge that under ‘modern conditions’ intangibles
were just as much an asset as tangibles, assuming of course that a proper value
could be determined. They could, in some situations, even be superior assets.
What Benjamin Graham said about intangible assets
‘Earnings based on these intangibles [e.g.
goodwill] may be even less vulnerable to competition than those which require
only a cash investment in productive facilities.
'Furthermore, when conditions are
favorable, the enterprise with the relatively small capital investment is
likely to show a more rapid rate of growth.
Ordinarily it can expand its
sales and profits at slight expense and therefore more rapidly and profitably
for its stockholders than a business requiring a large plant investment per
dollar of sales.’ Emphasis added.
How Warren Buffett looks at intangible assets
This last comment of Graham has importance for Warren Buffett, who seems to
really like companies with valuable, and sometimes irreplaceable, goodwill. To
Warren Buffett, it is this intangible good will, an asset that continually
produces profits without the need to spend money on maintenance, upgrading or
replacement, that adds value to a company. Consider what it is that is most
important in producing profits for Coca Cola: its name and recipe, or the
various factories that produce the drink.
Warren Buffett on economic goodwill
This is what Warren Buffett calls economic good will which he explained in
1983 like this:
‘[B]usinesses logically are worth far
more than net tangible assets when they can be expected to produce earnings on
such assets considerably in excess of market rates of return.’
Using by analogy, one of the favorite examples of Warren Buffett, take two
separate companies. Company A has a net worth of $100,000, $40,000 of which is
net tangible assets and $60,000 of which is intangible (brand name, goodwill,
patents etc). Company B has the same net worth but $90,000 its assets are
tangible. Each company earns $10,000 a year.
So Company A is earning $10,000 from tangible assets of $40,000 and Company
B is earning $10,000 from tangible assets of $90,000.
If both companies wanted to double earnings, they might have to double their
investment in tangible assets. For Company A to do this, it would have to spend
$40,000 to add $10,000 of earnings. For Company B to do this, it would have to
spend another $90,000 to add $10,000 to earnings. All other things being equal,
Company A would have better future prospects of increase in real earnings than
Company B.
The real profitability of a company
For these reasons, Warren Buffett has said that, in calculating the real
profitability of a company, there should be no amortization of economic
goodwill. Does the Gillette brand name actually decrease in value each year? Of
course not.
The thoughts of both Graham and Warren Buffett are worth consideration. Book
value is another ingredient in the investment equation.