Book value is a fundamental part of value investing. The metric is important because it gives a core value of a company. In theory, if a business declared bankruptcy, this is how much the assets would fetch at auction.
Of course, in the real world, book value is relatively unreliable. Some assets are only worth something to the company that owns them, and there is no telling how much an asset will be worth if it is sold at auction. Even tangible assets, which are generally considered to be entirely reliable, can end up being worth less than their recorded value once all is said and done.
Another big problem with valuing a company according to its book value is the fact it is very unlikely the average investor will ever be able to take advantage of the discount. For example, in his early career, Warren Buffett (Trades, Portfolio) was able to buy stocks trading at a deep discount to book value and then shake up the businesses to unlock value. As most average investors buy less than 1% of businesses when they invest, shaking up a company to unlock value is just not possible, and there is no real way to unlock value.
To put it another way, book value can be a misleading way of valuing a company, something Buffett has commented on many times in the past. Here are some of his comments on the pitfalls of book value:
"Of course, it's per-share intrinsic value, not book value, that counts. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimate of the cash that can be taken out of a business during its remaining life. At most companies, the two values are unrelated.
We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all- important and is the only logical way to evaluate the relative attractiveness of investments and businesses.” -1993 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) letter
The difference between book value and intrinsic value is key:
"Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.
It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings. Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.
An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. Thebook value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value." -Berkshire 1983 letter
And finally, why book value can be a misleading indicator of value:
"Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole.
Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980 to 1984, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30 to $50 million.
Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.
Ponder this: the economic goodwill attributable to two paper routes in Buffalo - or a single See’s candy store - considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people." -Berkshire 1985 letter
”‹Disclosure: The author owns no stock mentioned.
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