Warren Buffett Says Book Value Lost Its Relevance. “I Object!”

In the eyes of many, Book Value (BV), the metric traditionally favored by academicians as an anchor for the much revered albeit-lately-poorly-performing value factor, was sort-of pronounced dead on February 23, 2019. That’s the date of the latest Berkshire Hathaway (BRK-B) annual shareholder’s letter in which Warren Buffett, perhaps BV’s number-one non-academic fan stated, with respect to this year’s letter’s having departed from its long-standing tradition of opening with a statement of the change in the Berkshire’s BV: “It’s now time to abandon that practice.” As if to pile on, Buffett next stated “that the annual change in Berkshire’s book value – which makes its farewell appearance on page 2 – is a metric that has lost the relevance it once had.” That strikes me as a call to action — to defend book value! (I suppose it’s in character; I’m the guy who, at a writing workshop I used to attend responded to the multitude of fantastical dystopian submissions I’d been seeing by suggesting that I was might try to drum up a class action lawsuit challenging discrimination against zombies.)

© Can Stock Photo / Woolwerth

Putting On My Old Lawyer’s Hat

Personally, BV is not by any means my favorite valuation yardstick. I’ve tended to favor Price-to-Sales, Enterprise Value-to-Sales, Price-to-Estimated Earnings, and with a dash of comparisons to free cash flow (but not overdoing it because FCF can get very volatile and because accruals — another despised and discriminated-against metric — actually tells us more than many realize). I did include Price to Book Value (PB) in the pre-built “Basic: Value” ranking system I built for portfolio123.com but that wasn’t so much a matter of conviction but a sense that it ought to be there given my intent to create a fairly generic system users could edit if and as they wished.

Buffett’s letter did a number on my head. Should I revise that pre-built ranking system? Should I consider ceasing to use that ranking system in a separate large-scale factor-related project on which I’m working? That mental stalemate (along with another just-completed rush project) is why I hardly published anything in over a month.

But then, I remembered debates I used to have with George S. Meissner, who gave me my first law job, about defending people who absolutely-positively did it (which was pretty much the case for every one of our criminal defense clients). Everybody is entitled to have their rights asserted, he said. Even the guilty are at least entitled to make the prosecution go through the burden of proving guilt beyond a reasonable doubt under proper procedures and with properly admissible evidence. “What would you do if you were accused of a crime? Wouldn’t you appreciate that?” he asked. My answer: “I’d just hire you.”

Ultimately, though, he was right. Everybody is entitled to a defense; corrupt nursing home operators, killers . . . and of course zombies, and yes, even Book Value.

What, Exactly, Is Book Value

An accountant would explain that this is the purchase price of an asset, minus adjustments such as depreciation and amortization (fancy calculations that supposedly incorporate the deteriorating usefulness of that asset as time passes) plus adjustments for amounts you spend to improve the asset over the course of its life. Things then get complicated because accountants think in terms of double entry, which means we can’t ignore money used to purchase (and possibly improve) the asset . . . . 

Wake up, it’s not all that bad.

When we switch to the investor’s vantage point, we typically talk about the company as a whole, not each individual piece of it. Now, book value is the amount of “permanent” capital attributable to owners of the business (i.e., the shareholders), as opposed to creditors. (Non-permanent capital, formally referred to as “current,” means money the company money or other assets that is expected to depart quickly — in less than a year — as part of the ordinary day-to-day operations of the business, such as inventory that gets sold or money that will given to employees when paydays arrive, money that will be given to suppliers for all the stuff that was bought other than C.O.D., etc.).

Book Value and Intrinsic Value or Market Value

Now things get interesting.

In theory, book value is the value that should be received if a company is sold.

That’s pretty much the case when we sell a car. We expect to get, or at least the buyer expects to pay (forget what sellers expect, they always start with big dreams) the initial price of the car minus whatever amount the buyer can bludgeon the seller into accepting as compensation for wear and tear, plus the value of any new goodies being included, such as, perhaps, new tires that were added just last week.

It should be the same for a company; the price paid for the assets, less wear and tear plus the value of improvements. So logically, it might seem that the price of a publicly traded stock should be equal to its book value per share.

In the real world, it almost never works this way. In fact, among the 6,549 stocks in the Portfolio123 US Fundamentals Universe as of this writing (the really big universe that even includes lots of virtually un-tradable penny stocks), the number trading at a Price-to-Book Value (P/B) ratio of 1.00 was, exactly, zero. Adding a 5% margin of error above and below 1.00 produced only 227 stocks, a mere 3.5% of the universe. Among S&P 500 constituents, we find only 6 (1.2% of the total) within a 5% margin for error.

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Disclosure: None.

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