Putting Book Value and Price-Earnings Ratio in Perspective

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For most investors, the key to successful investing lies in reducing the complexity of the task at hand to a few easily understood principles. A common approach is to value a business by applying a few well-established ratios such as the price-earnings (PE) or price-book value (PB) ratio.

Benjamin Graham firmly believed that book value was a useful starting point to determine the intrinsic value of a business. Graham correctly assumed that shares trading at below book value could not continue to do so indefinitely. If the business was capable of remaining profitable on a sustainable basis, eventually the stock price would head north.

Yet, the diligent investor needs to exercise caution when using book value to determine intrinsic worth.

The first adjustment required is the need to value ‘intangible’ assets or goodwill. When a company makes an acquisition of a business and chooses to pay a premium to book value, the difference must be carried on the balance sheet as ‘goodwill’. Accounting rules require this ‘asset’ to be depreciated over a specified period of time. The difficulty relates to determining whether ‘goodwill’ has earning power or reflects managerial ego driven by the urge to preside over a larger empire! Graham was unequivocal in arguing that goodwill needs to be deducted from book value consistent with the view that it is at odds with a margin of safety. More often than not, the hubris that accompanies an acquisition justifies being conservative in valuing goodwill. Yet, the case to universally disregard the residual value of goodwill is clearly flawed. When an acquisition leads to either the purchase of a strong franchise, proprietary technology or a quasi-monopolistic business, the higher purchase price typically reflects the capitalised value of future ‘excess returns’. Therefore, it is vital to understand the context of a business in assessing the value of intangibles.

The need for the second adjustment arises from the accounting principle of valuing assets at historical cost or management’s perception of fair market value. The first rule in calculating liquidating value as Graham spelt out in Security Analysis is to assume that all liabilities are real but that all assets are of “questionable value”. While cash equivalents and marketable securities pose no problem, valuing assets such as inventories, receivables and plant & equipment could be somewhat trickier.

Receivables, the money due from merchandise sold on credit, should be valued at a slight discount to stated balance sheet value primarily because of the risk of non-payment as well as the time period that may elapse prior to all dues being collected. As a basic rule, the longer it takes a company to collect receivables, the greater the discount that needs to be applied.

The primary risk with inventories is obsolescence/perishability and fluctuations in market price. While fixed assets are adjusted by a ‘depreciation’ rate, the real issue relates to the ‘economic’ life versus the ‘accounting’ life of the assets. This difference can cut either way and quite often the gap can be significant. A gas transmission and distribution utility has a network of pipelines that directly define its economic earnings power. In this instance, the economic life of the assets is far longer than dictated by accounting requirements and consequently, an established franchise within a specified geographic domain has significant hidden value. Equally, if a fully depreciated plant is well maintained and reasonably efficient, the asset will be dramatically understated in terms of its value thanks to high inflation.

Book value can be deceptive in a number of industries, most notably for branded consumer staples, pharmaceuticals and knowledge-driven service franchises. This explains the tolerance investors have for extremely aggressive PB ratios in evaluating these industries. Conversely, stated book value may be undeservedly low for asset-rich real estate developers, particularly in a high-inflation environment.

In essence, book value has limited use in judging upside but is highly relevant in determining the minimum level to which a stock might decline. On balance, provided there is demonstrable evidence of predictable earnings, it is eminently sensible to buy stocks trading at close to their book value.

By far the most commonly used yardstick to value a business is the PE ratio. In effect, this number tells you the number of years required to re-coup your current investment assuming earnings remain constant. Consequently, the PE multiple reflects consensus judgment on:

• The prospects for revenue growth
• Expectations related to future profitability, and seen in conjunction with the previous point, resultant increases in per share earnings
• Changes in the rate of growth for revenues and earnings per share
• The state of the economic cycle and the need to correspondingly normalise current earnings

Much like book value, PE multiples need to be put in perspective with regard to what the index is trading at, comparable numbers for the peer group within the industry and a long-term historic trading range. In addition, it is essential to appreciate that the earnings represented in the denominator are not affected by exceptional or non-recurring items and are based on prudent accounting norms.

One other ratio that is commonly used is the price-sales (PS) multiple. This metric is most frequently associated with small-cap growth companies. Yet, the PS is virtually redundant in an absolute sense since the underlying assumption is that sales are growing and profitable. The only rational way to benefit from PS ratios is to evaluate them jointly with operating profit margins. Intuitively, companies with superior margins should trade at a higher multiple. This makes for sensible investing since higher margins typically result in higher earnings, which in turn leads to a quicker payback. Experience suggests that in using these ratios the truly smart move may be to pay a somewhat higher multiple to own a business with disproportionately superior earning power.

Building on these thoughts, a company that merits serious consideration is FAG Bearings (Rs 1,365). Despite facing major headwinds in 2012, the company achieved 11 percent growth in revenues and earned an EPS of Rs 95. Put differently, this translates into a 19 percent return on equity in its toughest year during the last decade.

Another way to understand the exceptional earning power of the company is to look at 10-year averages for the period 2003-12—35.7 percent ROCE, 25.8 percent ROE and 27.3 percent compounded annual growth in profits after tax! An improving macro-economic outlook, more specifically declining interest rates, should be a major positive for future growth. The disproportionate earning power in a humdrum business combined with the tremendous margin of safety (PE 14, PB 2.6 and PS 1.6) make FAG Bearings a compelling long-term investment.

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author frequently invests in the shares discussed by him.