In the world of traditional Ben Graham value investment, the logical investor seeks out companies that provide a great deal of security in tangible assets, and they seek to pay a fair price for them and their earning power. Tangible assets are things you can feel and can be assumed to be items on the balance sheet that can directly produce or contribute to the manufacturing or sale of an item, namely, property, plant and equipment.
In addition to other important ratios about a company’s liquidity and debt, the price to book and price to earnings ratios are the easy ones to identify. A price to book of one would indicate that you are paying market value for the company’s assets and a price to earnings of 15 would mean you are paying 15 times the value of assets for earnings ( if P/B=1 and P/E=15). The combination of the two multiplied should not surpass 22.5; this would indicate a fair value if a company could pass other important historical benchmarks.
In the world of tech, this can be deceptive. Many items within the book value of a company producing new technology may have to do with patents and good will, items that are valued by the company and comparisons to its peers, yet may have no market itself if the items need to be sold. These items might never produce or contribute to the production of company goods and be written off as their usefulness is determined to be null. Even though tangible assets will be depreciated as intangible items are amortized, the likelihood that the tangible assets will continue to have a useful life and produce positive income during the same accounting periods is much higher.
Let's take a look at the ratios of some common company’s tangible to intangible asset ratios. (Note: current assets, receivables, short and long-term securities are excluded for a simplified comparison.)
First off, Western Digital (WDC, Financial); their tangible to intangible asset ratio is 68.25% ttm. The hard drive company recently acquired SanDisk (SNDK, Financial), which carried some intangibles with it, but this ratio has been near one to one or greater in some periods past.
AT&T (T, Financial);Â AT&T’s assets are only comprised of 55.24% tangible ttm.
IBM (IBM, Financial); IBM’s assets represent the largest divergence from tangible asset balance with 30.21% of assets in the tangible category ttm.
Google (GOOG, Financial) and Apple (AAPL, Financial) represent two of the strongest tech companies when it comes to this asset ratio. Google has a tangible to intangible ratio 1.47X greater than intangible assets and Apple’s is a whopping 2.49X . Apple is doubly strong, being that they also carry a lot of cash on the balance sheet and $164 billion in long-term investments (much of that capital is operated through their Reno, Nevada, subsidiary Braeburn Capital.)
Wal-Mart (WMT, Financial) is not a company involved heavily in technology (not yet at least). Just for a comparison, their tangible versus intangible assets are 6.8X greater. This is a company that relies on property plant and equipment to generate income more so than the majority of the S&P 500, and we can make logical assumptions about the reliability of their earnings in forward earnings reports.
While being as strict as a 1920s value investor when evaluating a company’s balance sheet in the modern world is no longer a feasible means of investing, the lower that ratio becomes, the more you are paying for the unknown. Paying 9.35X Book for a company with 30% tangible items on the balance sheet (such as the case with IBM), leaves a lot to the imagination and less to logic.
Disclosure: The author is long WDC. The author holds no positions in APPL, WMT, GOOG, IBM or T.
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