Intrinsic value and book value are two very different numbers. Book value is often used as a shortcut to estimate a company's worth, an approach that can work in certain circumstances but that has lost much of its effectiveness as the stock market has evolved in recent decades.
In particular, asset-heavy businesses, such as steel producers, miners and railroads, are nothing without their assets. They produce a commodity product, and they may have limited intangible assets, such as brand values or unique technology. Therefore, book value could still be used as a shortcut to estimate intrinsic value for such companies.
The drawbacks of book value
I use the word "could" in the paragraph above because book value is just one number, and it is an incredibly blunt tool. Like all estimates of intrinsic value, book value only gives one figure, a figure which is based on a company's own balance sheet numbers. It provides no clue as to the management of the assets, the quality of the assets, or their realistic second-hand value. Many steel mills or mines have been marked down to negligible values by one operator only for another operator to take over and transform the asset's prospects.
For example, in a recent deal, mining giant Glencore (LSE:GLEN, Financial) agreed to buy its outstanding interest in a coal mine for $294 million. It expects payback in two or three years. That suggests an IRR of 33.33% per annum. The value of the asset was clearly worth a lot less to the sellers than it was to the buyer. This example illustrates why book values can be completely irrelevant and why other estimates of intrinsic value can be more reflective of real value, although this is all still highly subjective.
At the 2013 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders, Warren Buffett (Trades, Portfolio) provided an example of why book value can be a highly misleading figure. He stated:
"I should point out, incidentally, that we use book value because it's a calculable figure, and it does serve as a reasonable proxy of the year-to-year change in the intrinsic value of Berkshire.
If we could really give you a figure for intrinsic value, and back it up, that would be the important figure. As I pointed out, if we gain a million policyholders at GEICO, that actually adds a billion-and-a-half to intrinsic value, and it doesn't add a dime to book value. So, there's a significant gap, which is why we're willing to buy in stock at 120%of book value — a significant gap between the two.
But book value is a useful tracking device.
I should point out also — I did this in the annual report in respect to Marmon — when we buy the ISCAR stock, which we pay about $2 billion for, the day we buy it, we mark it down in terms of our book value by roughly a $1 billion. So a billion dollars comes off our book value for making a purchase which we regard as quite satisfactory. And so there are these distortions that occur."
This quote presents the benefits and drawbacks of book value. Yes, it can be misleading, and it regularly fails to reflect the actual value of businesses. However, it can be a useful yardstick to measure a company's worth.
Not clear cut
Like so many topics in the world of investing, the topics of book value and intrinsic value are not clear cut. Both have their uses in business valuation, but neither is ever going to be 100% accurate. Indeed, as intrinsic value has no fixed calculation, it is probably the more unreliable of the two. At least book value has some basis in accounting. One can only guess the intrinsic value of an intangible asset like a brand. In contrast, its construction value can more easily define the value of a factory.
So overall, both book value and intrinsic value have their uses. It may be better not to rely on just one metric and use a combination instead to try and reduce the impact of any weakness in estimates.
