Someone who reads my articles sent me this question:
Geoff,
I think most of your readers understand that every business is unique and therefore requires varying valuation techniques. However, I think that we could benefit from some advice from you on how to recognize what techniques are appropriate for which general type of business… For example, net-nets are easy – in its most simplified form you could ask yourself, “Are the current assets (or some discounted version of them) greater than the total liabilities?” If the answer is yes, you know this is a net-net and should be valued as such.
But what questions would you ask to realize that a certain company is best valued on a price/book value? Maybe something like, “Does the company have a strong intangible brands?” would clue you in that book value is not the right way to look at it? Or, “does the current book value represent reality?” might help you with asset-heavy companies like railroads where P/B might be misleading? Or why would you decide that book value is the most appropriate metric?
What questions would you ask to realize that a certain company should be valued on GAAP earnings rather than FCF? Maybe something like, “How does depreciation affect cash flow?” or something like, “How does growth cap-ex affect FCF?”
What questions would make you think that P/Sales is the right metric to focus on?
Thanks again,
Matt
How do you value a company? How do you know what is a relevant metric and what isn’t? It sounds so hard. But it’s actually easier than it appears. What you need to do – and this is common sense, but it’s amazing how few people mention this – is consider the best use of the asset you are appraising. So, for example if Coca-Cola (KO, Financial) is worth some huge multiple of its tangible book value this is not really because tangible book value does not matter at Coke – it’s because tangible book value is not even remotely the best use to which the company could be put. Coke’s assets are best used as part of a global super brand. Likewise, Dun & Bradstreet (DNB, Financial) has a negative tangible book value. Is this relevant? Or does it not matter at all? Well, tangible book value would matter at DNB if the company’s tangible book value was high relative to the company’s stock price. If you could take the company’s assets and put them to some other use – which is kind of the general principle we are discussing when we use tangible book value – then that is always relevant when it exceeds the company’s stock price. So, a high net current asset value, a high tangible book value, etc. is always relevant. Is a low value always relevant?
Not really. Statistics obscure this. If you look at stock returns, it’s often the case that companies with very high price-to-book ratios will underperform stocks with rather lowish price-to-book ratios. That makes it seem like price-to-book is this continuous spectrum of highly relevant information. It’s not. Price-to-book is very relevant when it’s low. Price-to-book has special relevance when it is low. At best, it has general relevance when it is high. So, for example, a company with a high price-to-book ratio may be a bad purchase in part due to its high price-to-book value – but this is not so much a special issue having to do with price-to-book. Rather, the stock likely has too high a price-to-earnings ratio, price-to-sales ratio, etc.
Look at the metrics that really matter:
· Price to net cash
· Price to net current assets
· Price to tangible book
· Price to earnings
Now let’s flip that order:
1. Price to net cash
2. Price to net current asset value
3. Price to tangible book value
4. Price to earnings
The first use is the lowest use. You can buy the company’s stock and simply pay out the cash. Even a loss making company has value to someone who can contest control of it – if the company has net cash. Next is net current assets. This is working capital. We’re talking about cash, receivables, and inventories. To some extent, we are talking about liquidation value. NCAV is not a perfect proxy for liquidation value. But whenever a company is selling below its net current asset value, it’s a pretty good indicator that a company is selling below its liquidation value. There can be some strange exceptions. But, usually, a company’s non-current assets have some value. And this value will often make up for any overstatement of current assets on the books.
Also, note the way current assets are accounted for. What we call cash is usually either of a very short maturity or is marked to market. It’s rarely overstated or understated by much. Receivables are stated net of doubtful accounts. And inventories are carried at the lower of cost or market. We’ll call that cost. In other words, the book value of receivables is no higher than the amount owed (it’s often lower) and the inventory is stuff that the company routinely sells for a higher price than it keeps it on the books for.
So NCAV has some padding built in. When you add in whatever the company’s non-current assets are really worth you see why Ben Graham used NCAV as a proxy for liquidation value. And while it’s true that in the modern world there are plenty of off balance sheet liabilities and wind down costs that didn’t exist in Graham’s day, it’s also true that some companies have valuable intangibles on their balance sheets that would have value in liquidation. These include the rights to a name. So, overall, it doesn’t make a lot of sense to argue about NCAV versus liquidation value. Unless you are an expert on liquidations or the type of company you are researching – you’re unlikely to come up with a more realistic assessment of a stock’s liquidation value than its NCAV.
Next is tangible book. This one’s tricky. It’s basically a proxy for replacement cost. It’s saying that if a company already exists and can’t make money in an industry, why would other companies enter that industry? So, if a Company has a $100 book value and earnings of $3 a share – it is earning 3% on its equity. Well, 30-Year AAA corporate bonds now yield closer to 4%. So, why would anyone start up a new business to compete with the old business – presumably lowering both their returns in the process – if it could make more money buying some silly old bonds instead.
Now, of course, there are plenty of reasons why companies do this all the time. You want to avoid any industry where you think companies will continue to invest in expansion even beyond the point where it makes economic sense.
But we also need to keep in mind that at many companies we’re looking at tangible book value that is actually understating the cost to a new entrant of building the same business – sometimes by a lot. So as long as competitors are relatively rational and nobody is stuck in a situation of constantly having too much capacity relative to the demand needed to earn decent returns on invested capital – tangible book value should be another value proxy.
In this case, we are approximating the value of a business once capital has flowed where it ought to flow. In a terrible business – that means out of the industry. In a great business – that means into the industry. For various reasons, price-to-book is a trickier proxy than some of the others. It’s something you should investigate yourself. You want to make sure the stock’s book value bears some resemblance to the replacement cost of the company’s resources (both tangible and intangible). The quick and convenient approach is just to assume that tangible book value approximates replacement cost and that replacement cost approximates intrinsic value.
In some cases this is totally untrue. For example, the replacement costs of railroads – which are regulated – are much, much higher than their tangible book value. There are even some companies where the concept of replacement cost is close to meaningless because their resources are irreplaceable (this usually has to do with where the asset is). Sadly, there are companies who own lots of assets that would not exist if they had the choice of building them anew today. Would Barnes & Noble (BKS, Financial) have as many stores today if it had known in the past what the current demand – and expected future demand – for printed books would be?
No.
And nobody in their right mind would decide they want to start a newspaper today. Newspapers exist in this world merely as a vestige of a time when they served a useful function. For some folks, newspapers still serve that function. But those folks would be served in a different way if there hadn’t once been a time before the internet. That’s the environment in which newspapers evolved. They are not well suited to today’s environment. So their tangible book value may be meaningless. But unless you have reasons for assuming subpar economics will continue in an industry for the very long-term there’s no good reason to assume a company won’t one day trade at its tangible book value.
The obvious exception to this is when a company is distressed. If a company has a bad Z-Score, F-Score, etc. and could be headed toward bankruptcy – then obviously it may never get a chance to trade at tangible book value. So, always judge safety separately from price. And ensure the stocks you buy meet both criteria:
1. Safe
2. Cheap
Next is earning power. You can think of this as a business’s “franchise value”. This is the value of a business with some kind of moat. Without a moat, a business will earn returns similar to those of other businesses with equal amounts of capital tied up in their operations. While inflation and other factors may cause even mediocre companies to have intrinsic values that diverge from their stated book value – the truth will be that they are not worth some multiple of earnings apart from assets. In the end, their intrinsic value is tied to their assets. It is not tied to the special use to which those assets are being put.
So, if a company is unique in some way – if it has a defensible competitive position – you can value it based on earnings alone. This is the best use of the company’s assets. And you always value a company according to its best use. Obviously, if a company’s moat is breached and you expect it to slide into mediocrity – then it should be valued for its generic assets and not for the special competitive position it holds.
So, basically these are the 4 ways of valuing a company:
1. Cash
2. Current Assets
3. Tangible Book
4. Earnings
If we really wanted to get detailed and theoretical I’d say there are 2 other uses. There is the company’s use in a takeover. In other words, it’s value to a competitor. And there is the company’s value to a stock speculator. As Buffett and Munger have said before stocks are partly valued as productive things and partly valued as collectibles. They are partly valued because they have assets and cash flows and so on. And they are partly valued because they go up. And people like things that go up. And they want to own them. And they want to speculate in them.
Of course, making all this even more complicated is the issue of present day figures versus future figures. In some cases, it is possible to estimate the future to some extent. And in those instances, stocks are not valued according to today’s earnings alone but according to expected future earnings. This, of course, raises the issue of growth. Which is a topic for another day.
For today, the important thing is to think of each of these values as lines of defense. A stock that is worth 15 times earnings is also worth its tangible book, and its net current assets, and its net cash value. It’s just that these values are much, much lower than the company’s value as a wide-moat business with consistent earnings. So we only consider earnings.
But appraisal always involves finding a stock’s best use. So, you can work down this list in reverse asking how confident you are in each number:
1. Earnings
2. Tangible Book
3. Net Current Assets
4. Cash
If you aren’t confident in a stock’s earnings – move on to tangible book. If you aren’t confident a stock is worth tangible book – for example: a perpetually money losing business – move on to net current assets. If you aren’t confident in net current assets (which probably means the inventory is dodgy) move on to net cash.
Work through the list that way. If a company has good earnings, book value, etc. and yet you manage to buy that stock at its NCAV or net cash – well, that’s a bonus.
But appraisal means working through that list from top to bottom: earnings, tangible book, NCAV, cash – and stopping at the first number you can count on.
Ask Geoff a Question about Price Ratios
Check out the Ben Graham Net-Net Newsletter
Check out the Buffett/Munger Bargains Newsletter
Geoff,
I think most of your readers understand that every business is unique and therefore requires varying valuation techniques. However, I think that we could benefit from some advice from you on how to recognize what techniques are appropriate for which general type of business… For example, net-nets are easy – in its most simplified form you could ask yourself, “Are the current assets (or some discounted version of them) greater than the total liabilities?” If the answer is yes, you know this is a net-net and should be valued as such.
But what questions would you ask to realize that a certain company is best valued on a price/book value? Maybe something like, “Does the company have a strong intangible brands?” would clue you in that book value is not the right way to look at it? Or, “does the current book value represent reality?” might help you with asset-heavy companies like railroads where P/B might be misleading? Or why would you decide that book value is the most appropriate metric?
What questions would you ask to realize that a certain company should be valued on GAAP earnings rather than FCF? Maybe something like, “How does depreciation affect cash flow?” or something like, “How does growth cap-ex affect FCF?”
What questions would make you think that P/Sales is the right metric to focus on?
Thanks again,
Matt
How do you value a company? How do you know what is a relevant metric and what isn’t? It sounds so hard. But it’s actually easier than it appears. What you need to do – and this is common sense, but it’s amazing how few people mention this – is consider the best use of the asset you are appraising. So, for example if Coca-Cola (KO, Financial) is worth some huge multiple of its tangible book value this is not really because tangible book value does not matter at Coke – it’s because tangible book value is not even remotely the best use to which the company could be put. Coke’s assets are best used as part of a global super brand. Likewise, Dun & Bradstreet (DNB, Financial) has a negative tangible book value. Is this relevant? Or does it not matter at all? Well, tangible book value would matter at DNB if the company’s tangible book value was high relative to the company’s stock price. If you could take the company’s assets and put them to some other use – which is kind of the general principle we are discussing when we use tangible book value – then that is always relevant when it exceeds the company’s stock price. So, a high net current asset value, a high tangible book value, etc. is always relevant. Is a low value always relevant?
Not really. Statistics obscure this. If you look at stock returns, it’s often the case that companies with very high price-to-book ratios will underperform stocks with rather lowish price-to-book ratios. That makes it seem like price-to-book is this continuous spectrum of highly relevant information. It’s not. Price-to-book is very relevant when it’s low. Price-to-book has special relevance when it is low. At best, it has general relevance when it is high. So, for example, a company with a high price-to-book ratio may be a bad purchase in part due to its high price-to-book value – but this is not so much a special issue having to do with price-to-book. Rather, the stock likely has too high a price-to-earnings ratio, price-to-sales ratio, etc.
Look at the metrics that really matter:
· Price to net cash
· Price to net current assets
· Price to tangible book
· Price to earnings
Now let’s flip that order:
1. Price to net cash
2. Price to net current asset value
3. Price to tangible book value
4. Price to earnings
The first use is the lowest use. You can buy the company’s stock and simply pay out the cash. Even a loss making company has value to someone who can contest control of it – if the company has net cash. Next is net current assets. This is working capital. We’re talking about cash, receivables, and inventories. To some extent, we are talking about liquidation value. NCAV is not a perfect proxy for liquidation value. But whenever a company is selling below its net current asset value, it’s a pretty good indicator that a company is selling below its liquidation value. There can be some strange exceptions. But, usually, a company’s non-current assets have some value. And this value will often make up for any overstatement of current assets on the books.
Also, note the way current assets are accounted for. What we call cash is usually either of a very short maturity or is marked to market. It’s rarely overstated or understated by much. Receivables are stated net of doubtful accounts. And inventories are carried at the lower of cost or market. We’ll call that cost. In other words, the book value of receivables is no higher than the amount owed (it’s often lower) and the inventory is stuff that the company routinely sells for a higher price than it keeps it on the books for.
So NCAV has some padding built in. When you add in whatever the company’s non-current assets are really worth you see why Ben Graham used NCAV as a proxy for liquidation value. And while it’s true that in the modern world there are plenty of off balance sheet liabilities and wind down costs that didn’t exist in Graham’s day, it’s also true that some companies have valuable intangibles on their balance sheets that would have value in liquidation. These include the rights to a name. So, overall, it doesn’t make a lot of sense to argue about NCAV versus liquidation value. Unless you are an expert on liquidations or the type of company you are researching – you’re unlikely to come up with a more realistic assessment of a stock’s liquidation value than its NCAV.
Next is tangible book. This one’s tricky. It’s basically a proxy for replacement cost. It’s saying that if a company already exists and can’t make money in an industry, why would other companies enter that industry? So, if a Company has a $100 book value and earnings of $3 a share – it is earning 3% on its equity. Well, 30-Year AAA corporate bonds now yield closer to 4%. So, why would anyone start up a new business to compete with the old business – presumably lowering both their returns in the process – if it could make more money buying some silly old bonds instead.
Now, of course, there are plenty of reasons why companies do this all the time. You want to avoid any industry where you think companies will continue to invest in expansion even beyond the point where it makes economic sense.
But we also need to keep in mind that at many companies we’re looking at tangible book value that is actually understating the cost to a new entrant of building the same business – sometimes by a lot. So as long as competitors are relatively rational and nobody is stuck in a situation of constantly having too much capacity relative to the demand needed to earn decent returns on invested capital – tangible book value should be another value proxy.
In this case, we are approximating the value of a business once capital has flowed where it ought to flow. In a terrible business – that means out of the industry. In a great business – that means into the industry. For various reasons, price-to-book is a trickier proxy than some of the others. It’s something you should investigate yourself. You want to make sure the stock’s book value bears some resemblance to the replacement cost of the company’s resources (both tangible and intangible). The quick and convenient approach is just to assume that tangible book value approximates replacement cost and that replacement cost approximates intrinsic value.
In some cases this is totally untrue. For example, the replacement costs of railroads – which are regulated – are much, much higher than their tangible book value. There are even some companies where the concept of replacement cost is close to meaningless because their resources are irreplaceable (this usually has to do with where the asset is). Sadly, there are companies who own lots of assets that would not exist if they had the choice of building them anew today. Would Barnes & Noble (BKS, Financial) have as many stores today if it had known in the past what the current demand – and expected future demand – for printed books would be?
No.
And nobody in their right mind would decide they want to start a newspaper today. Newspapers exist in this world merely as a vestige of a time when they served a useful function. For some folks, newspapers still serve that function. But those folks would be served in a different way if there hadn’t once been a time before the internet. That’s the environment in which newspapers evolved. They are not well suited to today’s environment. So their tangible book value may be meaningless. But unless you have reasons for assuming subpar economics will continue in an industry for the very long-term there’s no good reason to assume a company won’t one day trade at its tangible book value.
The obvious exception to this is when a company is distressed. If a company has a bad Z-Score, F-Score, etc. and could be headed toward bankruptcy – then obviously it may never get a chance to trade at tangible book value. So, always judge safety separately from price. And ensure the stocks you buy meet both criteria:
1. Safe
2. Cheap
Next is earning power. You can think of this as a business’s “franchise value”. This is the value of a business with some kind of moat. Without a moat, a business will earn returns similar to those of other businesses with equal amounts of capital tied up in their operations. While inflation and other factors may cause even mediocre companies to have intrinsic values that diverge from their stated book value – the truth will be that they are not worth some multiple of earnings apart from assets. In the end, their intrinsic value is tied to their assets. It is not tied to the special use to which those assets are being put.
So, if a company is unique in some way – if it has a defensible competitive position – you can value it based on earnings alone. This is the best use of the company’s assets. And you always value a company according to its best use. Obviously, if a company’s moat is breached and you expect it to slide into mediocrity – then it should be valued for its generic assets and not for the special competitive position it holds.
So, basically these are the 4 ways of valuing a company:
1. Cash
2. Current Assets
3. Tangible Book
4. Earnings
If we really wanted to get detailed and theoretical I’d say there are 2 other uses. There is the company’s use in a takeover. In other words, it’s value to a competitor. And there is the company’s value to a stock speculator. As Buffett and Munger have said before stocks are partly valued as productive things and partly valued as collectibles. They are partly valued because they have assets and cash flows and so on. And they are partly valued because they go up. And people like things that go up. And they want to own them. And they want to speculate in them.
Of course, making all this even more complicated is the issue of present day figures versus future figures. In some cases, it is possible to estimate the future to some extent. And in those instances, stocks are not valued according to today’s earnings alone but according to expected future earnings. This, of course, raises the issue of growth. Which is a topic for another day.
For today, the important thing is to think of each of these values as lines of defense. A stock that is worth 15 times earnings is also worth its tangible book, and its net current assets, and its net cash value. It’s just that these values are much, much lower than the company’s value as a wide-moat business with consistent earnings. So we only consider earnings.
But appraisal always involves finding a stock’s best use. So, you can work down this list in reverse asking how confident you are in each number:
1. Earnings
2. Tangible Book
3. Net Current Assets
4. Cash
If you aren’t confident in a stock’s earnings – move on to tangible book. If you aren’t confident a stock is worth tangible book – for example: a perpetually money losing business – move on to net current assets. If you aren’t confident in net current assets (which probably means the inventory is dodgy) move on to net cash.
Work through the list that way. If a company has good earnings, book value, etc. and yet you manage to buy that stock at its NCAV or net cash – well, that’s a bonus.
But appraisal means working through that list from top to bottom: earnings, tangible book, NCAV, cash – and stopping at the first number you can count on.
Ask Geoff a Question about Price Ratios
Check out the Ben Graham Net-Net Newsletter
Check out the Buffett/Munger Bargains Newsletter
