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The Pleasure of Finding Things Out - Why Book Value and Why 120% Part I

May 24, 2014
Grahamites

Grahamites

142 followers

In my previous article, I discussed the importance of differentiating knowing the names and numbers from knowing the meanings of names and numbers. In the end, I suggested that we should start cultivating the habit of exploring the meanings and implications of investment terms and company (industry) specific numbers. This article is my humble attempt to delve into the concept of book value and Buffett’s 120% book value repurchase rule.

As Buffett followers, we all know that Mr.Buffett has repeated stated that over the long run, book value growth is a good proxy for Berkshire’s intrinsic value growth. In recent years, he added that buying Berkshire up to 120% book value makes a lot of sense. For a while, I’ve taken these statements as granted without thinking about why. The answer may seem obvious to more experienced and more savvy investors. But when I ask myself why book value and why 120% a couple of days ago, I was unable to give myself a satisfactory answer. So I spent a few days searching for the answer. I’m not sure I have found the right answer yet but here is what I think what the answer is.

Let us start with the definition of book value. The standard definition of book value seems very straightforward: book value is the result of subtracting liabilities from assets. In other words, we can think of book value as residual assets value.

But this definition of book value doesn't help us too much in terms of understanding why it is a good proxy for Berkshire's intrinsic value. Here it may be helpful to think of book value from an equity owner's perspective. In the accounting equation, assets minus liability equals shareholders' equity, which incidentally is also the definition of book value.Therefore, book value is theoretically what equity holders can get out of a business. In other words, it is what the business is worth to all the equity holders.

Ok, now we are getting closer to the answer, but still not quite there yet. If in theory, book value is what matters to equity holders, why can't we measure every business's intrinsic value growth using book value growth? That would save us a great amount of time.

To answer that, we will have to go even further to look at the components of book value, or shareholder's equity. In doing so, the Statement of Owner's Equity, which is often completely ignored by the investment public, will be tremendously helpful. If you look at the Statement of Owner's Equity for any company, you will find out that the change in equity has the following components:

Common stocks and capital in excess of par value
Retained earnings
Accumulated other comprehensive income
Treasury stock
Non-Controlling interests

We can roughly think of the first component as equity owners' contribution to the business. This component will mainly increase if the company issues more shares and it will decrease if the company retires common shares or through transactions with non-controlling interests.

Retained earnings is net income minus dividend paid. If all the transactions are conducted in cash, retained earnings can be thought of the amount of capital available for business ownders to reinvest. Obviously this component will grow with net income and will shrink with dividend and net losses.

Accumulated other comprehensive income may be less familiar to readers with limited accounting background. The concept of other comprehensive income is more straightforward than what the name implies. Other comprehensive income is simply the potential after tax gains or losses that are not ready to be recognized yet. And accumulated other comprehensive income is the cookie jar reserve for those future income and losses that are not ready to be recognized yet.

For example, if your business bought a share of Coca Cola for $10 a share during the year and held it through year end when Coke's share appreciated to $15 per share, this $5 unrealized gains and losses from will show up in OCI and AOCI at year end. If your business sold it for $16 a share next year, the $5 dollar unrealized gain will be released from AOCI and transfer to realized gains, which is part of net income, which will flow through retained earnings. The other $1 profit (6-5) will be directly booked as net income without taking a detour to AOCI.

If you are confused with OCI and AOCI, think of OCI as net income and AOCI as retained earnings without dividend. Like net income, OCI is reset to 0 at the beginning of the year. Like retained earning, which is not reset to 0 and accumulates with more income, AOCI is also not reset to 0 and accumulates with OCI.

There are a few common OCI accounts such as net change in unrealized gains and losses from investments, foreign translation gains and losses and actuarial gains and losses of defined benefit pension plans. I will save the readers' pain by avoiding getting into the details here. Enough is to know that for Berkshire, net change in unrealized gains and losses from investments is usually the biggest driver.

AOCI goes up with more unrealized gains and goes down with either unrealized losses or the transfer of unrealized gains to realized gains.

Readers may have noted that I've spent a good amount of time and effort discussing AOCI. This is necessary because it is significant to Berkshire as unlike other businesses, Buffett and Munger's preferred holding period is forever. It will become more clear as we progress further.

Moving on to Treasury Stock, this component is well known. It is the repurchase of shares by the business.It increases with more repurchases. One thing to note here is that Treasury Stock decreases the equity value on aggregate but the effect on per share equity value depends on the repurchase price. It is the per share equity value that the matters to equity unit holders.

Last but not least, Non-Controlling Interests is the portion of equity ownership in a subsidiary that is not owned by the parent company, who has a controlling interest in the subsidiary and thus consolidates the subsidiary's financial statements.

For example, when Berkshire first purchased 90% of Nebraska Furniture Mart for $55 million, Berkshire consolidated all NFM's assets and liabilities on ints own balance sheets because it controlled the business. However, since it didn't own 100% of NFM, Berkshire would have to show on the balance sheet the 10% of NFM that it didn't own at the time of initial purchase of the 90%. This 10% still owned by Mrs.B would show up on Berkshire's balance sheet as non-controlling interest under the equity section. When Buffett purchased the remaining 10% of NFM, this 10% minority interest was removed from the equity section of Berkshire's balance sheet.

Ok, we still haven't answered the question yet but I think the readers have a good idea on where I'm going with this. I must admit that this task is taking much longer than I thought it would be. So please forgive me for explaining some accounting terms in details in this article as I think these are crucial to understand in order to see how they connect to book value and intrinsic value growth. To keep things more digestible, I'll stop here. Now we have the foundation blocks laid out, we'll keep exploring in the next part of this article series


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Comments

ToTheTruth
ToTheTruth - 5 months ago

Warren uses book value because the financial industries are often valued using book value as a starting point. An average bank or insurance company that earns 10% return on equity averaged over a full cycle will typically trade near book value.

Financial companies that earn substantially more than 10% return on equity over a full cycle will trade much higher than book value. A good example is Progressive (trading at about 2.4x book value). It trades higher than book value because investors expect it will earn a much greater return on equity over a full cycle.

This is very similar to Berkshire Hathaway insurance companies which is why they are worth more than book value.

Berkshire also has a lot of "other subsiduaries." These shouldn't necessarily be valued based on "book value" as much as sustainable profits and how good of returns reinvested capital will produce. However, if you value these subsiduaries separately and add up the total and check your numbers over a period of years, you will find this puts (Berkshire Total Calculated Value/Berkshire Book Value) in a narrowish band.

Warren would not bother repurchasing stock when it's price was close to his calculation of intrinsic value. He wants a wide discount.

That is how Book Value is a "decent proxy" for intrinsic value. Hope that helps!

mikechan2020
Mikechan2020 - 5 months ago

Hi, I agree with ToTheTruth that some of the intrinsic value is not shown on the book as Berkshire is famed of buying many subsidiaries at a discount to their intrinsic value.

And, I think one of the other key points is the widened moats of their buseinsses. Those subsidiaries' moats may have been widened and the value of their assets would certainly be higher than what they cost when they were bought.

I also remember Buffett once talked about the goodwill of Geico. He said its goodwill was all about the ability to use the float. I guess the ability (goodwill) to use the float has been growing over the years after he bought the business. The goodwill, however, is not subject to revaluation while the true value is definitly higher than before. Hence the book value must be undervalued, especially when Berkshire is all about widening the moat.

Not an English speaker, so please bear with my poor grammar.

Grahamites
Grahamites premium member - 5 months ago

ToTheTruth and Mikechan 2020: Thank you both for your comments. I would share with you my thoughts on a few points raised in your comments:

Warren uses book value because the financial industries are often valued using book value as a starting point. An average bank or insurance company that earns 10% return on equity averaged over a full cycle will typically trade near book value.

To me, this might not the root reason why Warren uses book value as a starting point. I doubt Buffett uses it because everybody else is using it. We can then ask ourselves, why book value is a good starting point for banks and insurance companies, right? This will make us explore further. We can also ask the question why would an average bank or insurance company trade near BV if it earns 10% ROE over a full cycle?

These shouldn't necessarily be valued based on "book value" as much as sustainable profits and how good of returns reinvested capital will produce. However, if you value these subsiduaries separately and add up the total and check your numbers over a period of years, you will find this puts (Berkshire Total Calculated Value/Berkshire Book Value) in a narrowish band.

This is a very good idea, although it sounds daunting as Berkshire has so many subsidiaries and some of them are too small to disclose. But I'll see if I can work my way through.

ToTheTruth
ToTheTruth - 5 months ago

Buffett uses it and everyone else uses it because it makes sense to value financial companies in such a way. You have to make some adjustments, of course, but it is an excellent starting point. If a bank is selling at 0.5x Price/Tangible Book Value and it is earning a return on equity of 10% and is a fairly average bank, it is a great buy. If it is earning a 5% return on equity and is a below average bank, it is probably closer to the neighbourhood of fairly priced.

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