Benjamin Graham, the man who is widely considered to have invented value investing, built his investment strategy around a company's balance sheet.
Graham wanted to buy stocks that were trading at a discount to their book value. This, he believed, gave shareholders a margin of safety. He thought that investors who paid $0.50 for every $1 of book value would do well because even if the company failed and it was broken up, shareholders would still be entitled to $1 for every $0.50 invested when all other creditors had been settled.
This investment style worked very well for the Godfather of value investing and his students throughout the mid-1900s. Warren Buffett (Trades, Portfolio) built the foundations of his fortune in these early years. Many other former students of Graham successfully employed this strategy as well.
However, over the past decade, book value has become much less critical to a company's success. Intangible assets such as intellectual property, educated staff and brand value have become significantly more important and influential in a company's success, rather than the total size and value of its asset base.
Companies have been able to take on more debt as a result of this (as well as many other factors). This has had an impact on the liabilities side of the balance sheet. Liabilities have increased as assets have remained stagnant. This has decreased shareholder equity and book value per share.
All of the above suggests that book value no longer has any place in value investing, in my opinion. It also indicates that it has become harder to calculate intrinsic value over the past decade, and detailed knowledge of the companies and sectors investors are considering is required.
An example
A great example of this is Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial). Buffett's conglomerate is, at its core, an insurance business. The investment portfolio and other divisions such as Berkshire Hathaway Energy and BNSF provide complimentary capital to the business' insurance side.
With a typical insurance company, most analysts believe that a business is not worth more than its book value. This is because insurance tends to be a fairly hit-and-miss business, with most companies in the sector only producing a moderate return on assets every year.
However, analysts who know and understand Berkshire will be able to see that this conglomerate has a competitive advantage in the form of its size and experienced underwriting team. Because of the group's size, it can underwrite risks that virtually no other insurance group would be able to. The size also guarantees all stakeholders that the group will be around in many years' time to pay liabilities when they fall due.
These competitive advantages suggest that Berkshire is worth more than its book value, and this is something Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), have addressed in the past.
Berkshire isn't the only business where this is applicable. Many tech sector companies are worth significantly more than their underlying book value because of the intrinsic value benefits they provide both to customers and the rest of the business.
A case-by-case basis
Having said all of the above, while it may no longer be suitable to value some businesses on book value, it remains a good indicator for others. Book value for real estate companies, for example, provides a good gauge of the asset-heavy companies' financial flexibility and solvency as well as balance sheet strength.
So, while book value may be "dead" in some cases, investors should review each opportunity on a case-by-case basis. It may also be sensible to use book value alongside other valuation methods to develop a range of intrinsic values for individual businesses.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Buffett Adds to Bank of America: More Deals on the Way?
- Investment Lessons from Jesse Livermore
- What We Can Learn from Carl Icahn's Wall Street Career
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