Question for the fundamentalists out there

[Warren Whitmore]

From kiplinger "...in some industries-insurance and finance, for example book value per share isn't considered particularly significant. In general, when the figure is available, you want it to be on the low side."
This makes no sense to me why would I want it to be on the low side?

[adios]

I'm not sure what Kiplinger means but here's my take. BV means a lot less for companies like Microsoft than it does for companies like say Annaly Mortgage. In the Microsoft case the first thing is that MSFT's most valuable assets are intangible assets that don't show up on the balance sheet. Microsofts most valuable asset is their source code seeing that the source code is the most important asset for driving revenue and earnings. The value of source code is nowhere to be found on it's balance sheet or any other software companie's balance sheet.

Annaly is a mortgage REIT who invests their cash in Mortgage Backed Securities (MBS) who uses a "carry trade" to leverage their cash. The leverage ratio they use is about 10-1. They borrow 10 times their cash at a very low rate and purchase MBS with that money and make money off of the spread between the rate they borrow at and the rate that the MBS pay. This is very similar what a bank does when it pays depositors a lower rate than what they lend money at. BTW bank leverage ratios tend to be much higher than 10-1. There isn't much intangible value in a company like Annaly Mortgage except for what management brings to the table in their expertise in managing a portfolio of MBS but bear in mind that management expenses are quite high. Also Annaly's portfolio is quite liquid. Therefore a company like Annaly should trade much closer to BV and it does.

In reality BV probably isn't that important in valuing the vast majority of companies on the exchanges. I do like to look at the balance sheet though and scrutinize the assets and liabilities of companies. It's time consumming and I'm not sure how much money it really makes you. Generally speaking BV is used as a metric in valuing the value of companies, sectors and indexes.

[Wildbill]

People are getting into book value today and here is something to think about. There are some companies out there that are extremely aggressive about buying back shares. I used to work for a company that went all out buying back shares, to the point that treasury capital was actually negative. How we did that was by taking out a big loan (notes issuance) at what was a great rate that helped us exploit our strong credit rating. If we cared about book value it would have been stupid to do that, but frankly book value is not worth much for healthy companies. Paying for shares with profits is nice, but many times buying back shares with debt is excellent for your returns and should be undertaken as long as you don't overdo it. To the play it safe investor today that gets too caught up in book value, that might be a company he thinks is run by idiots, but in corporate finance theory its an excellent way to beat your return on capital hurdle rates and should add value for your shareholders.

If you pay attention to these things, you will notice book value is only brought up for companies that are running quite poorly. Further its used quite poorly, someone saying "Company X is below book value!!" while completely ignoring its financial situation and commitments. Look, its nice to think if the doors closed tomorrow the shareholders could get more money than they pay for the stock today, but its terribly unrealistic. Keep in mind companies always have tons of contractual obligations to their suppliers, to their employees, to their landlords, etc. Those must be paid and yet book value pays that no heed. Book value also is a terribly backward way to look at numbers. That includes every dollar of profit ever made, but its not like that is cash sitting around for the company. They reinvest it and it may not be worth anything close to what they paid for it and it could be generating far less than they expected of it. Also book value is just an accumulating number. A business that has been around since 1920 may have a huge number there, while its competitor only started up in 1995. Does book value matter here??? The company from 95 could be kicking their booty right now because they took losses first 5 years really developing a deep market and product and now it pays off. The old company now has its solid book value which makes for a great ratio because its stock is trading down. Why it trades down so low? Precisely because the young turk has come in and is making the old company's future look very cloudy.

I can't believe that this has happened, the obsession with book value. I have a degree in accounting, but work in finance these days. I can tell you if you are an investor that the future is where its at. Forget all this past stuff, the emphasis on accounting is going too far. If there is fraud, yes that is an issue, but remember that financial statements are really useful to investors for one thing and that is to make educated guesses as to what might happen in the future. These newly fashionable investors that spend all their time looking at financial statements for last 3 years and then calculate ratios based on things like book value are not going to be terribly effective. They will win some and lose some, but their methods aren't going to do anything earth shattering. Investments are future based, always always always. Forget yesterday, it means very little if you are buying the stock today. And at least for today, the market is always right, once again always always always.

The most money made in the market is by the people that properly spot growing companies, not cheap companies, and then move out of them when their particular growth story plays itself out. That is where the money is. The money isn't in saying Company X should be valued at $10, but the stupid people in the market only see it worth $7. That is the attitude of the petulant school child, rarely does this person get anything done on their schedule. Sure they could make money in the very long run, but only after the company finds the wind finally at its back and it becomes this growth story that I speak of. If you want to be a value investor over the long run, just be a Peter Lynch and find something you like for the long run and buy it when those moments of opportunity come up and it trades below its usual valuation. That will fit your needs, but once again that is a method that pays little heed to book value or accounting numbers and pays more to the markets it serves and the demand you expect for its product.

I know a lot of people will argue about it, but these facts are very much true. The market isn't a perfect financial world, there are emotions that are stoked by the common thinking of the time. Why else would such a silly metric as book value be getting so much play by even people that ignored it a few years ago??? Believe me, book value is about as useless as it can get. Its a backward looking number and one that has little useful application at that. Put it simply, if someone thinks they can find a business that could close the doors and have more cash left over than trading value today, be very very skeptical. They frankly cannot possibly know that is true. While companies do disclose most commitments, they can easily miss some that add up. Further unless you really think companies close the doors and don't pay a penny in severance and stiff their creditors across the board, remember there are liabilities that are incurred daily and they must be paid. So once again, please heed my advice and pay little attention to book value if you want to find good investments.

[scalf]

/forums/images/icons/smile.gif mister softy makes a real product, but it's real value is due to it's intellectual property..(source code)...hmmmm..amazing that you would admit there is value due to intellectual property...although, msft does actually sell a msft product..even though it is useless without placement in a far more expensive product....

think msft was smart to defend their source code and fight with ftc...was the millions paid lawyers worth it???


hmmm?

jmho..gl /forums/images/icons/smile.gif /forums/images/icons/spade.gif

[scalf]

/forums/images/icons/smile.gif scalf's thoughts on book value...

people want it now because it is (supposedly) something tangible; something they can (supposedly) sell if company (or overall market tanks)...

big problem is: book value is highly subjective and volatile..note the big write-offs among computer firms when stuck with tangible real objects...they lost value as cheaper competition became available....or take a look at punch presses in auto plants...get replaced by more efficient, robotic, computer controlled, metal forming devices....

in banking...a lotta companies try hard to max assets, but there has to be a balance between risk/loan reserves/ and the evaluation of risk in loans is subjective...

in short, ya want a company that is likwly to vastly increase earnings in near future..jmho..gl /forums/images/icons/crazy.gif /forums/images/icons/cool.gif /forums/images/icons/club.gif

[Warren Whitmore]

"In the short run the market is a voting machine; in the long run, it's a weighing machine."
"I try to buy securities that are undervalued based on assets more than earnings. I do a better job on assets than earnings because earnings have a way of changing."
I have always felt that the analogy between a persons individual finances and the market is: assets are to net worth as earning are to ones pay check. In poker terms this means I would rather buy "stock" in Ray Zee than in Stu Ungar because in the long run Ray is going to have more money even though Stu is capable of earning more. This seems contrary to all of the responses that I have recieved so far. Thanks for the responses as I have learned a few things in the area of non accountable assets.

[adios]

Well if there's something that I know anything about it's software and software development. Giving away the source code is giving away too much so yes I think they did right thing by refusing to divulge their source code. Apparently I've posted some negative MSFT stuff. IMO the issues about MSFT revolve around whether or not they are an illegal monopoly. My understanding of anti-trust laws is that it's ok to be a monopoly as long as the monopoly status is obtained legally. Many court cases regarding anti-trust laws and only one I believe has not supported this view. However, in a peculiar way I don't like investing in software companies as a rule. But yes IMO MSFT's most valuable asset is their intellectual property in the form of source code.

[Wildbill]

Book value and assets aren't one and the same. And his theory is exactly what I say, either buy something long because you see value in the markets its products server, or live in the short run buying stocks that are in the right zone of a growth spurt and then sell when the story isn't as strong. While no one can argue that Buffett doesn't have a great track record, remember the numerous edges he has over the average investor. Namely, if you go out and buy shares of a company, you can't influence or help out their management much. Warren has resource that can help. Maybe Coke isn't calling for help, but a lot of his smaller companies have benefitted from his capital and his people's financial knowhow. It allows them to become focused on the entrepreneurial side that they are best at, not the financial day-to-day which sinks a lot of even good businesses. So while you might be able to spot some good valuation bargains, don't start believing they will lead to untold riches. And I guarantee you Warren doesn't care about book value either. I know he is a strong believer in ROI and efficient financial management. Neither of these are based on book value.

[adios]

I'm not doubting that Buffet said that but I'm wondering what book you found it in. I'd like to read it if you'd be so kind to pass it on.

Every book I've read on valuation more or less states that the assets dedicated to the conitinuing operation of a business should basically have a value of zero dollars. The books don't put it quite this way but that's the meaning. The rational is that corporations are assumed to run in perpituity i.e. forever. So the break up value of assets dedicated to continuing operations will never become an issue (certainly an acquirer like Buffet can buy them though /forums/images/icons/smile.gif).

I would look at lots of balance sheets to learn about assets and liabilities.

[Warren Whitmore]

The name of the book is "Warren Buffett speaks" its has lots of fun quotes in it. Here are a few
1)My health is terrific. I just went for the first time in six or seven years for a general checkup. The doctor asked me about my diet and said, your counting rather heavily on your genes aren't you?
2)Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it dosen't do an good to look at the cards.
3)I have seen no trend toward value investing in the 35 years I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult."

[scalf]

/forums/images/icons/tongue.gif i would argue that buffet knows how to truly value assets; and very important..and, knows how to buy assets cheaply, and combine them in a way that creates cash flow...but saying that is the same thing as book value misses the point....entirely...jmho..gl..i think if ya buy a share of buffet for 65k or so..it will be 550k in 10 years..more than he postulates..gl /forums/images/icons/cool.gif /forums/images/icons/diamond.gif

[Ray Zee]

any company's value is really only its breakup value. the value if its sold out. same as with a person. sell off all their assets and thats the value. but stocks also are given a current value which is the price they trade at. that value is solely based upon what the company looks like it is going to earn in the near future. basically its the P/E ratio more or less but close.
you can also throw in blue sky and good will and other such things. but they only apply when sold to a willing buyer who expects to keep the company going.
my premise is that a stock trades at its earning value so when you make the decision to buy or sell thats what you use to decide. you job is to guess correctly which way its going. thats why i always say buy or sell stocks where you see a change happening, and bet in the direction of what the change will be.
then you must weigh the earning potential with the current forcast for the cost of money. thats your cost to hold that stock. especially with ones that do not pay dividentds.

as to dividends. would you buy a stock if told they would never pay a dividend to investors. that means you never recover your investment. a public company is nothing more than a private business that sold shares. would you invest in a friends company if he told you you would never get a return, and your only salvation would be to find another buyer for the shares.( the greater fool theory)

[GrapeJuice]

Ray, your thinking is off. A company's value is not it's current break-up value. A company's value is it's break-up value in the future, discounted to a present value.

Of course, the amount that the company earns between now and the time it's liquidated plays a *huge* factor. Normally, you expect that the amount that the company earns between now and the end would stay with the company or be doled out in dividends. And hopefully, those earnings will far outweigh present "book value" or present liquidation value. That's why we buy these companies for the long-run (for those of us who believe in the long-run).

You wrote: "as to dividends. would you buy a stock if told they would never pay a dividend to investors."

Yes, I would! If the company can use the money well to create more money then the company should hold on to the excess profits! In the distant future, should the company liquidate, if holding onto the excess profits creates a larger liquidation value then that should affect market price of the company. The effect on market price should hold true not just in the distant future, but also in the present because of the expected future value of the company!

[GrapeJuice]

Here's why you want book value to be on the low side:

When a company claims, for instance, a piece of real estate, it's value is part of the 'book value'. But the value of that real estate that's actually booked is the purchase price of the real estate. So if a company holds a piece of land that it bought in 1906 for $20,000 and it's worth $1,000,000 now, it's carried on the books at $20,000. On the other hand, if the property goes down in market value, that's booked immediately. Since the appreciation in value is never booked until the property is sold, you want book value to be way on the conservative side. See, if someone doesn't look carefully enough at the company, they won't notice that (in the example above) the company is worth at least $980,000 more than it at first appears.

[Wildbill]

Ray also misses the easy to overlook, but hard to ignore factor that many of these companies give off their cash in an indirect way by buying back shares. Most partnerships work this way and so it is in the stock market. You and 3 buddies start up a business today. In a few years its obvious one buddy just isn't into it, so someone or all of you buy him off and pay him based more on the valuation at the day you make the deal, not the value he bought in at when you started. Same with companies, while you think they might not issue dividends, if they are willing to buy 10% of the shares that is essentially saying we will go out and buy out the 10% of the shareholders that have the least faith in our future business and we will even give you what the market thinks is a fair price today. While of course its not that simplistic, it still works and gives you a reason to buy something that may never pay standard dividends, but gives you an assurance that you can get your value out of an investment before breakup.

Further Ray might dismiss goodwill, but the concept is very true. You might make a damn good hamburger, but if you stand is Ray's burgers and your across the street competitor is named McDonalds, who do you think will get more business and why? That is the concept of goodwill. If Ray makes such good hamburgers and builds a bunch of his restaurants, he has created goodwill. That goodwill is worth a lot more than the restaurants or equipment he has. The brand name generates more business and higher future profits per store than just a one-store burger business. Breakup value really has almost nothing to do with valuation and earnings isn't as important as its cracked up to be. Indeed discounted cash flows is the best way to value a business, but since companies sell stock like its a fashion statement, so many people miss this point. It reminds me of back when people were paying huge mulitples on Microsoft stock when it already was insanely profitable and big. Someone did the math showing that the only way to justify buying it is if you thought it would be something like 20% of the US economy in 10 years, or something like that. It was utterly ridiculous, but then again that was the world we lived in not so long ago. Things definitely get out of whack, but if you focus only on breakup value you will miss out on the point of owning a company.

[adios]

"The effect on market price should hold true not just in the distant future, but also in the present because of the expected future value of the company!"

Come on it doesn't always work that way. You can be totally right and be wiped out. I disagree that the market prices that effeciently. IMO if you are correct then yes the market does prices very effeciently. I don't think the evidence supports that level of efficiency. This ties into wildbill's post below. The hardest thing for me to finally grasp about the stock market was that prices can literally go anywhere and everywhere and be justified in doing so. Put another way, any kind of discounted cash flow model which could and should take into account other factors such as franchise value can imply some huge trading ranges by changing a few parameters slightly.

As far as being totally wiped out. A few years ago somebody posted about whether or not MO was a good buy. It was trading at $20 a share. I chimed in and said no sell it. Of course it took off from their and went over $50 a share. I noticed that today it went out at about $32. It wouldn't surprise me at all to see that stock end up below $20 a share. Let's say that in a year from now MO trades at $10 a share. If it did was I wrong 2 years ago or was I right? Here's another example. I hardly ever watch Rukheyser. However, there was a controversy about 4 years ago where one of his "elfs" was perpetually bearish saying the NASDAQ at 2000 and the Dow at 8800 or whatever were overpriced. She kept on saying it as the market went higher. Rukheyser fired her for being wrong. Was she though? Finally as I've stated before about dividends. Here is the gist of something Mike Milken said way back when.

"I prefer high yielding bonds to stocks. When I find a high yielding bond that is undervalued I start collecting money right away and if the market never agrees with me I've still collected all the coupon payments and redeemed the bond and still make money. I never have to have the market agree with me that the bond is undervalued to realize it's value. When I find an undervalued stock I have to have someone else agree with me that the stock is undervalued. If I never find someone to agree with me I will never realize it's value and if I do I may have to wait for a very long time. I have to have the market agree with me that it's unvervalued but with the high yield bond I don't."

[Wildbill]

Market worries about weird things is about all I can say. At certain times some worries are more in vogue than others. Right now people are just so enamored with free cash flow and strong balance sheets its silly. Those might have been useful last couple years, but they aren't worthy of adding some premium on top of a stock yet many are doing just that. "Certainty of results/cash flow" they say. What it reflects is that people are afraid of the opposite and just refuse to buy it at any price. Then with the money they have they overinvest in things that exhibit these characteristics they want. Supply and demand takes over and these stocks get overpriced relative to what are perceived as risky stocks. Risky stocks sometimes go bad, but not always and to avoid them completely means you are probably overpaying for what stocks you do hold. If this strategy reflects enough portfolios then you will get pricing imbalances and that is where I see them right now.

People have just gotten so risk averse today that you have to wonder. My thinking is that they got so burned by the burst of the bubble that they have taken a turn in the completely wrong way. When it comes down to it there is always risk in being in the market. That has to be accepted. The key is to pick a relative risk level and keep your investments at that level of risk, regardless of market sentiment or situation for the duration of your investment horizon. You can change your risk tolerance slowly over time as you get closer to retirement age, but that should also be carefully planned out. You shouldn't be getting more risky for awhile, get burned and then turn tail and go full bore conservative. Yet this is the inclination of the market and is why pricing can get messed up very easily. Those that just avoid risk today are quite obviously going to be consistent market losers, the guys or gals that can't figure out why they can't beat inflation with their returns.