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The Importance of Price to Book Value

July 22, 2014
John Emerson

John Emerson

144 followers

"Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost assures it."~ Seth Klarman (Trades, Portfolio)

Readers of my investment articles are well aware of my affinity for investing in businesses which trade at attractive discounts to their tangible book value (or in some cases a discount to hidden book values). Currently, such entities are almost as difficult to locate as a volunteer fry cook at a nudist colony. That said, at some point in the future, the market will correct and a litany of price to book values discounts will once again present themselves to the investing community. Most of these potential bargains will exhibit diminishing earnings yields in the form of a declining price to earnings ratio. At this point the trick will be for investors is to discern whether the equities are in terminal decline or whether their earnings yields and future cash flows will once again return to their former levels.

Most value investors subscribe to the notion that a stock is worth the value of its future cash flows--thank you Mr. Graham for that undeniable edict. So why would a value investor decide to focus upon the net worth of a business rather than upon the earnings power of the company. First of all, the net assets of a business are less susceptible to variation--as Walter Schloss pointed out--and secondly, the tangible assets of most businesses are instrumental in the generation of earnings. The latter notion is frequently lost upon investors who have been programmed to primarily focus upon earnings. After all, what good are a set of assets that do not result in significant earnings or cash flows? What good is owning a garage if it full of hula-hoops or a bar that serves very few customers?

The answer lies in the reality that most businesses are cyclical in nature and most investors fail to realize that basic fact of economics. Moreover, many investors fail to comprehend the notion that a company which owns a set of lightly depreciated assets is typically worth far more than a similar business which possesses a set of assets which are almost fully depreciated, particularly if the business with the worn out assets is trading at a substantially lower price to earnings multiple. Such investors disregard the reality that capital-intensive businesses have cycles of their own in terms of how much cash that they will generate in the future, since free cash flow cycles are largely a result of the quality of the tangible assets which they possess. The reason being is that impending maintenance capital expenditures will temporarily hamper future free cash flow. The notion is counter intuitive to most investors; however it is seldom lost among the company’s competitors who sometimes launch buy-out offers when the price to book value discount of a company becomes too steep.

Let me take this discussion of the importance of the balance sheet one step farther: current assets are an essential component of the liquidity of most businesses. The goal of a prospering business should be to fund its operations (and growth if it exits) from its cash flow from operations. Such entities have a built in margin of safety. Businesses with little equity and low current assets in relationship to current liabilities, often find themselves reliant upon short-term borrowing to fund day to day operations. In that regard, businesses with high price to book ratios (and/or low current ratios) are much riskier than businesses which trade at sizable price to book value discounts. Further, leverage which supports liquidity (short term borrowing) is particularly risky during periods of economic slowdowns. That observation applies in spades for financial institutions during such periods. The practice of borrowing short and lending long was one of fundamental conditions which led to financial crisis of 2008 and 2009 but that is a story for another day.

Of course Benjamin Graham recognized the importance of liquidity in businesses in establishing a margin of safety. Graham recommended that investors only purchase stocks which held current ratios (current assets divided by current liabilities) of at least two. Investors who choose to purchase equities which possess low current ratios had better be certain that the inventories of such businesses turnover rapidly and consistently and that accounts receivables are collected on a timely basis. The higher the current ratio (particularly if the current assets include a high percentage of cash), the greater the margin of safety for the business.

One final point, businesses which require revolvers to supplement day to day operations need to have assets as well as EBITDA to meet the covenants of the loan. Businesses with low price to book ratios typically have a better chance of securing favorable financing than high price to book businesses so long as they display sufficient EBITDA. Further, capital-intensive businesses generate higher depreciation expenses which are deducted from the EBITDA formula. On the down side, such companies find it significantly more difficult to grow earnings than businesses with low capital requirements, another reason for insisting on low price to book ratios when purchasing companies which require significant tangible assets to generate earnings.

Allow me to illustrate the aforementioned points by comparing the abbreviated balance sheets of two hypothetical businesses. Let’s say these companies are remodelling businesses, an industry which holds notoriously low barriers to entry and is highly cyclical in nature.

Lets say Company A is up for sale at 100,000 dollars and has averaged 50,000 dollars in pretax earnings for the last ten years. Suppose Company B is asking the same sale price but has only generated an average of 25,000 dollars in pretax profits in the trailing ten years. If these two businesses traded on a public exchange most investors would undoubtably prefer the former company without regard to the value of the assets Company B, since the pretax earnings yield in substantially higher for Company A. But is Company A really the better choice?

Company A

Current Assets Cash =$5,000 Total Current Assets=25,000

Long Term Assets Goodwill=50,000 + 20,000=70,000

Current Liabilities 20,000

Long Term Liabilities 0

Total Equity 50,000

Tangible Equity 0

Company B

Current Assets Cash=20,000 Total CurrentAssets=60,000

Long Term Assets Tangible=150,000

Current Liabilities 10,000

Long Term Liabilities 0

Total Equity 200,000

Tangible Equity 200,000

An examination of the balance sheets of the two mythical companies provides some clarity:

-Neither business carries any long term debt and holds long term assets. Company A carries $20,000 on the balance sheet for Plant and Equipment which has been 90% depreciated. Company B shows 150,000 for Plant and Equipment of which 10% is depreciated (the depreciation percentage is not included in the abbreviated balance sheet).

-Company A was purchased at some point and carries 50,000 of goodwill on the balance sheet. It shows total equity $50,000 on its balance sheet.

-Company B has equity of $200,000 all of which is tangible.

-Company A has $25,000 of current assets and $20,000 of current liabilities, reflecting a current ratio of 1.25.

-Company B has $60,000 of current assets and $10,000 of current liabilities, reflecting a current ratio of 6.00.

-Company A has a price to book value of 2x but it has zero tangible book value.

-Company B has a tangible price to book value of .5x.

When quizzed about the superior profitability, the owner of Company A proclaims: 1) They generate high margins due to the employment of skilled salesman which they train themselves 2) They excel at lead generation, and 3) They travel farther to do business which eliminates competition.

Company B generates greater sales but has a significantly lower operating margin; although the EBITDA margins for Company B are not nearly as lopsided since the business records much higher depreciation expense. These depreciation expenses include: newer trucks, more extensive ownership of equipment (Company A rents much of its equipment), and a much larger warehouse which holds a significant amount of frequently used inventory.

A review of the 10-year financial records of the two businesses reveals that earnings fluctuate significantly and both companies had two years when they recorded negative earnings.

The advantages of purchasing Company B appear to be immense in terms of its net assets, yet the overall earnings history of Company A belies that assumption. Moreover, the return on equity would seem to indicate that Company A is much more efficient at producing profits.

In reality, the higher profits and returns of Company A are being achieved by the assumption of risk which is not apparent to the casual observer. First of all, the business could quickly encounter a liquidity crisis should it sales suddenly weaken, if the company would encounter a production delay or if some of its customers were slow in paying their bills.

Further, the business is operating with minimal assets which make it susceptible to increased rental prices for equipment, commodity inflation since it stocks no inventory, as well as significant replacement and repair charges as its nearly worn out equipment begins to break down. Since both businesses operate in a highly cyclical environment the risk is magnified. The risk is further exacerbated by the fact that neither business possesses a durable competitive advantage in an industry which holds few barriers to entry.

Taking everything into consideration, Company B represents a much superior purchase with a significant margin of safety, while Company A represents a high risk proposition even though it shows a vastly superior 10-year earnings history in addition to a much higher ROE.

In the real world, Company B would never be offered for 100,000 dollars but Company A might. However, in the world of stocks similar companies are offered for sale on a routine basis. The only difference is that investors are offered small pieces of the business in the form of shares rather the option of purchasing the entire company.

In my judgement the vast majority of investors would opt for Company A based upon its superior earnings metrics and superior ROE. In reality those investors would be making an extremely risky investment which would likely result in a significant loss of capital as the business price dropped to a level which more closely resembled the replacement value of its assets.. On the other hand, Company B would likely appreciate to a value much closer to the replacement value of its assets. If that level was not achieved, a knowledgeable competitor would likely take advantage of the discount and make a buyout offer on the company. Of course one must first ascertain that the industry in which the business exists will remain viable going forward.

That in a nutshell is why Walter Schloss averaged 20% compound annual returns by focusing on price to book discounts and waiting them out. He simply chose the contrarian play with the greater asset value. In doing so he minimized his losses and let the upside take care of itself.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.9/5 (7 votes)

Voters:

Comments

Investor77
Investor77 - 1 month ago

Do you think that 2 business with same tangible book value should be valued the same even if they have extreme different suistanable ROC?

I think not...and that's why Buffet buy Wells Fargo even if the world is full of banks with less P/B...and that's why he buys See Candy, IBM, KO, etc etc...

Your mental model, if I understand correctly, say Yes

Investor77
Investor77 - 1 month ago

Of course for some people buying at low P/B has worked...like Walter Schloss...but he had to quit...he was not able to implement that style anymore...

And even in the best case scenario that you are able to make it work you have to diversify a lot and also you need a big turnover rate...

If you buy good business...you need even only 6 and you are done for years and years...sometimes decades...

Let's assume both style works (Buffett style and Schloss style) what you would prefer to be good at?It's not even close...

LwC
LwC - 1 month ago

Investor77,

FWIW the Brandes Institute has published several studies about the usefulness of low P/B for selecting stocks for investment consideration. These studies include their own research and also serve to update earlier research done by others. Brandes Institute, for the purpose of their studies, define "value" stocks as having relatively low P/B ratio and "glamour" stocks as having relatively high P/B ratio.

Here's the link to one of the published studies:

Value vs. Glamour Revisited: Historical P/B Ratio Disparities and Subsequent Value Stock Outperformance

http://www.brandes.com/docs/default-source/brandes-institute/value-vs-glamour-revisted-historical-price-to-book-disparities-us

Investor77
Investor77 - 1 month ago

Works too buying low P/E...and also low EBITDA/EV....and also low P/S...and probably every kind of buy low metrics...

I'm not arguing that on average it will not work...it will...

I'm arguing that it is a weak mental model to value stocks...on average (on a big sample size) it will work...but you have to diversify a lot and you need to have an high turnover (always selling and buying)...

Investor77
Investor77 - 1 month ago

I respect the author and I have read and I like all of his threads...just a matter of preference I guess...moreover he put his money where is mouth is so, again, I can only respect his attitude and point of view...

...but I prefer to think about book value the same way that Buffett has wrote in his annula letters and interviews....

John Emerson
John Emerson - 1 month ago
Donald Smith (Trades, Portfolio) did an interview in Graham and Doddsville a few years back where he quoted a study of nearly 50 years that documented that the lowest 10% percentile of price to tangible book stocks averaged over 15% per year, outperforming the S&P by around 5 points per annum.

That said, I never implied that all businesses should be judged merely by their tangible book values. That would be absurd since it would imply that all businesses possess identical amounts of economic goodwill (or none at all). Certainly, businesses which hold durable competitive advantages and significant economic goodwill are worth far more that the sum of their net assets.

The crux of the article was that cyclical stocks which hold little in the way of barriers to entry and virtually no competitive advantage, are better judged by their tangible book value rather than their trailing PE ratios. It implies that investors who purchase low quality businesses should only do so when they are trading at substantial discounts to their tangible net assets. It also implies that such stocks should be sold as they approach their book value; although such stocks tend to overshoot that value as they come into favor.

I believe that Graham would concur and I leave you with one of his most famous quotes: "Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions".

Thanks for the comments, I appreciate them immensely

Investor77
Investor77 - 1 month ago

I can only agree whit what you said...and it's very valuable info...

The problem that I had was in the implementation of that style of investing...

Probably you have found the way to make it work for you...I wasn't able...and I have also way less experience than you...

For what i have read about you run a relevatly concentrated portafolio...I guess you read the annual reports and you go extencivly valuing their competitive position and business model and accounting even if they are cyclical...

It seems, correct me if I'm wrong, that you put the same efforts and valuenting reasoning to judge them as you would judging high quality business...

So I ask, why shouldn't you go for high quality business instead?

Investor77
Investor77 - 1 month ago

I remember you thought that competitive advantage is hard to judge...probbly this is the reason we diverge a little...it's not so hard...at least it seems to me the same as distinguish a company from average to a "bad" company...

Investor77
Investor77 - 1 month ago

Moreover you know that book value it's not liquidation value at all...so at the and you have always to come back to the earning power (or liquidation value but that seems not to be your choice) to estimate a "margin of safety"...

John Emerson
John Emerson - 1 month ago

The key in purchasing out of favor cyclicals at discounts to book value is to be sure that the business is viable going forward. If they return to their former profitability then they have a bulit in margin of safety if they are purchased at significant discounts. Liquidation value is more appropriate for dying businesses. That said I seldom invest in dying businesses (unless I do so inadvertently) regardless of their discount even if they are significant net/nets. If you look at the list of terminal net/nets their are typically laden with Chinese frauds and "eight track" tape type businesses.

Finally in regard to the high ROIC multipliers with competitive advantages, I would have loved to own a See's Candy and hold it for a lifetime. The problem is that most businesses are like gold mines: they hold a limited amount of extractable cash flow, it requires significant capital expenditures to remove the cash flow and as the mine ages, the cash flow diminishes steadily. I am sure that even Buffett did not foresee the steady decline in print media or the gradual change in public opinion in regard to the toxicity of sugary beverages.

Thanks again for your thoughtful comments.

pravchaw
Pravchaw premium member - 1 month ago

"The problem is that most businesses are like gold mines: they hold a limited amount of extractable cash flow, it requires significant capital expenditures to remove the cash flow and as the mine ages, the cash flow diminishes steadily."

I don't see busineeses like P&G, J&J, MSFT, AAPL, WFC etc. like that - their "gold mine" seem to inexhaustible for the forseeable future. I don't think you can reasonably hope by buy these at < tbv even in February 2009 when most investors were totally terrified.

Otherwise a very good article. Thank you.

John Emerson
John Emerson - 1 month ago

Hi Pravchaw,

Astonishingly, Wells Fargo traded at aproximately 1/2 of its TB in late 2008 for a short period of time. The others were never close but of course they do not require a high amount of tangible assets to make profits. Such businesses are not the type which I was describing in the article since they rely upon intangible assets to record profits. Although it could be argued that their R&D spending should be included in their net worth since that is the life blood of their future profits instead of PP&E. In essence, it is equity that is not listed on the balance sheet. That is a notion I borrowed from Greenwald.

All that said your point is well taken. For some businesses, tangible book value is largely irrelevant and a few businesses possess durable earnings power which does not resemble mines.

Thanks for taking the time to comment.

pravchaw
Pravchaw premium member - 1 month ago

John, Thank you for taking the time to respond. I went back and read some of your earlier articles and now understand how you developed your investment philosophy. (thank you for those, they were superb). My experience is somewhat similar to yours and it looks like we are of a similar vintage,

Currently I am using a mix of tbv and cash return/owners earnings as my primary metrics for decision making on stocks. Integrity of management is critical. I am somewhat more accepting of non-tangible assets like R&D, human resources and value of brands within reason.

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