This article is the fifth in an introductory series on value investing that was first published in 2006 and went on to become the core of our book Value: The Intelligent Investor's Guide to finding hidden gems on the sharemarket.
See also: 1. The essence of value investing; 2. What price a margin of safety?; 3. How to value stocks; 4. Value investing, via Don Bradman; 6. Putting a price to earnings; 7. The delights of dividends.
In How to value stocks, the third instalment of this series on the Intelligent Investor equities teams' approach to stock selection, we saw that shares are worth the present value of the future cash they generate. We can either look at this cash in terms of the dividends paid out, or the net cash the company produces.
In spite of a few shortcomings (one of which we’ll come to shortly), this theory does provide a framework for comparing different companies whatever they do with their cash. But if you give an analyst a theoretical framework, he or she will give you a 15-page spreadsheet.
After all, if a company is worth the present value of its future cash flows, then why not put together a giant sum, calculating all those cash flows, discounting them back to their present value and totting them all up? Called "discounted cash flow" calculations, they’re all the rage these days but, curiously, not so much before the advent of the computer.
In practice, such valuations aren't worth the space they take up on your hard disc. First, you can get so wrapped up in the calculations it’s easy to forget about the numbers you put in. Second, as you combine estimates, the results become so rough to be of little use. Finally, there’s a temptation to award the final result too much credibility because of all the effort embedded in your elegant spreadsheet.
The better bet is to stick to a few simple valuation tools—such as ‘price-to-book’, dividend yield and PER—and then allow a fat margin of safety. But it’s essential to see these tools purely in the context of helping you reach an estimate of the present value of a company’s future cash flows.
The simplest tool of all is the price-to-book ratio, which is a company’s market capitalisation divided by its net asset value (or "book value"). Book value represents what the company has paid for all its stuff and what it would receive were it to sell it all and return the proceeds to shareholders.
The beauty of book value lies in its simplicity, although there are a couple of problems with it. First, book value doesn’t represent the value of a company’s assets but what it paid for them, less an arbitrary charge for wear and tear, and plus or minus the odd bit of accounting confusion.
So you have to be careful about the assets to include in your book value and the values ascribed to them. Plant and machinery dedicated to a declining industry might have a much lower value than that what is actually stated on the balance sheet. Other assets, like cash, have a more definite value. In between, there are things like inventory and debtors, whose value will depend on how confident you are that they can be converted successfully into cash.
Some assets, such as property, might be understated, and some valuable "intangible" assets, like brands, goodwill and intellectual property, might not even show up at all. The Coca-Cola Company (NYSE:KO) had a book value of $US25bn in April, but according to Interbrand, its main brand is worth $US78bn. Even that may be on the low side if the company’s US$200bn market capitalisation is anything to go by.
So it’s all a bit circular. All roads eventually lead back to the fundamental truism that a piece of capital is worth what it can earn.
Not all capital is created equal
Which gets us to our second problem—that companies don’t all make the same returns. Some companies consistently make returns far above average, either because of competitive advantages or good management, or both. Economic theory says these factors should be ironed out over time, but in practice they can hang around for ages.
All things being equal, then, a good business making high returns on capital will justify a higher price-to-book ratio than a poor business making low returns.
So the advantage of price to book is that it is quick and easy; the disadvantage is that it often won’t tell you much about a company’s value. That said, it can provide useful pointers.