Thursday, February 17, 2011

Why book value matters?

Most of the value investor understands the importance of book value in determining the intrinsic value of a company. Book value represents the hard assets including its inventory, fixed assets minus depreciation and its cash/receivables minus all the liabilities like provisions, accounts payable etc...Ben Graham suggests not to pay much higher than book value while buying shares of a company.

If this criterion is strictly followed, there might be some set of companies that an investor may not be able to invest in ever. These companies include FMCG firms like Nestle, HUL and GSK Consumer since they distribute most of their earnings as dividends and so the book value of the company does not increase much. These companies also work sometimes on negative working capital so their book value will be very less compared to their earning power and so their intrinsic value can only be calculated based on their earning power.

But in bull markets, like the one we are in, investor enthusiasm stops differentiation between these companies and average small/mid cap companies. See the following table for the examples:

* 2006 numbers
CompanyBook Value March 2005EPS March 2005Share Price September 2005P/B September 2005P/E September 2005Book Value March 2010TTM EPSShare Price TodayP/B TodayP/E today
Ador Welding63.3619.952604.113108.4521.221701.578
GMM Pfaudler36.395.21116.943.2122.4562.98.07941.511.65
GM Breweries25.63*14.3*117*4.57*8.18*60.1217.73101.81.695.74
India Nippon122.422.86286.52.3412.53187.1730.952421.297.82
Gateway Distriparks62.39*7.88*131.4*2.1*16.67*61.917.41201.9416.22
TV Today35.582.8396.152.733.9752.56-7.17621.18NA
Voith Paper141.1517.222001.4211.61217.8121.442000.929.33

Most of the companies were purely trading at that time based on their earning power and the importance of book value was completely ignored by Mr Market. After more than five years, they are trading at prices lower than what they were trading at in 2005. The loss is not even compensated from dividends since capital erosion is far more than the cash received by an investor from dividends. The story may not end here. In the bear market of 2001-2002, these vary companies were trading at a steep discount to their book value and the same may happen when the next bear market comes. This doesn't mean the investor should shy from buying these names since the loss would be a notional loss unlike the loss that has happened over the last five years which is real.

The typical experience of the speculator is one of temporary profit and ultimate loss. - Benjamin Graham
Image: jscreationzs /
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