Warren Buffett on Book Value

By Morningstar |  25-10-19 | 
 

Book value is a key measure that investors use to gauge a stock's valuation. Here are some basic points to comprehend the ratio, as well as views of Warren Buffett on the same.

What is the Book Value?

The value of a security on the day of purchase or the acquisition value.

Also refers to the amount of net assets belonging to the owners of a business based on the balance sheet values.

How is it calculated?

Book Value of an asset is the asset's cost minus the accumulated depreciation since the asset was acquired. It is the value at which an asset or security is carried on the balance sheet.

For example, a company buys a machine for Rs 100,000 and subsequently records depreciation of Rs 20,000 for that machine, the machine has a Book Value of Rs 80,000.

If a company has issued bonds with a maturity value of Rs 4 crores and its balance sheet reports Unamortized Bond Discount of Rs 8 lakhs, and Unamortized Bond Issue Costs of $2 lakhs, the Book Value of the bonds is Rs 3.90 crores.

Book Value = total assets - intangible assets - liabilities

What does it tell you?

Book Value represents a company’s worth if it liquidated its assets and paid back all its liabilities.

Value investors like to refer to Book Value when searching for stocks trading at bargain prices. If a stock trades below Book Value, it is an opportunity to buy the company's assets at less than they're worth. When compared to the company’s market value, Book Value can indicate whether a stock is under priced or over priced.

Book Value doesn’t do a good job of valuing intangibles such as extremely successful brand recognition, brand loyalty, intellectual property rights, extremely innovative culture. For example, a technology company may develop software at a relatively low cost, so their balance sheet entries for their major assets will fall well short of their true value.

Also, a company may own tremendous amount of real estate that gains in value while its machinery experiences a drop in value. In such an instance, Book Value at the historical cost would distort an asset or a company's true value.

Here are some observations from Warren Buffett.

Of course, it's per-share intrinsic value, not book value, that counts. Book value is an accounting term that measures the capital, including retained earnings, that has been put into a business. Intrinsic value is a present-value estimate of the cash that can be taken out of a business during its remaining life. At most companies, the two values are unrelated.

We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all- important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

  • 1993 LETTER TO BERKSHIRE SHAREHOLDERS

 Book value's virtue as a score-keeping measure is that it is easy to calculate and doesn't involve the subjective (but important) judgments employed in calculation of intrinsic business value.

It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings. Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child's education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.

1983 LETTER TO BERKSHIRE SHAREHOLDERS

Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole.

Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980 to 1984, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30 to $50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo - or a single See's candy store - considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.

  • 1985 LETTER TO BERSHIRE SHAREHOLDERS
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