Looking at book value the Buffett way
Many investors see book value to assess valuations. Warren Buffett tells us why this method is not sound
By Research Desk | Nov 1, 2018
How often have we used the price-to-book ratio to screen for value stocks? Truth be told, many of us would stand guilty of this habit. It's one we can't seem to get rid of. We look at the price-to-earnings ratio and the price-to-book ratio to assess the attractiveness of an investment. But how does the world's greatest investor view book value?
The importance of book value
Let's get straight to Buffett to see how he views book value. 'Well, generally speaking, book value has got nothing to do with the price at which you should purchase your shares; intrinsic business value does. And the correlation between intrinsic business value and book value throughout the investment universe is - you know, there's virtually no correlation. So book value is unimportant to most companies.'
'The really wonderful businesses require no book value'
A really wonderful business does not require book value. This is what Buffett said in one of his annual shareholder meetings: 'The very best businesses, the really wonderful businesses, require no book value. We want to buy businesses, really, that will deliver more and more cash and not need to retain cash, which is what builds up book value over time.'
Could a low price-to-book be signalling a low-quality business?
A low price-to-book stock is enticing to many investors. It indicates that the stock is cheap in relation to its book value. Take Company A trading at a price-to-book of 0.10x, Company B at 0.11x or Company C at 0.24x. Does the low valuation make them attractive?
Now what if we tell you Company A is Unitech, Company B is HDIL and Company C is JP Associates. Are any still attractive?
Sure, you can buy the assets of these companies for far less than what they could be worth, but ask yourself if the attractiveness of a low price-to-book of these companies outweigh the many issues each of them faces? Also, would you be comfortable if you had to hold these stocks for 10 years?
A low price-to-book in many situations signals something more than just low valuations. Here's Buffett explaining this: 'A low price-book ratio means nothing to us. It does not intrigue us. In fact, if anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we're looking at a poor business in the first case and a good business in the second case.'
The lure of the price-to-book stock screen
Many of us have at some time in the past combed through a screen with stocks quoting at a low price-to-book. Does Buffett do the same in searching for stocks?
Here's Buffett's response, 'We don't really use screens...it's not like we sit there and say, you know, we want to look at things that are below the price of book value, or low P/Es, or something of the sort. We are looking at businesses exactly like we'd look at them if somebody came in and offered us the entire business, and then we try to think what this is place going to look like in five or ten years, and how sure are we of it.'
You are not alone
Here's a little secret. While Buffett has made it clear that he does not use book value when looking for stocks to buy, he has admitted to using it early on in his career. The important takeaway is to understand why Buffett moved away from picking stocks this way and understand how it has worked for him.
'Prior to the purchase of See's Candies in 1972, I intended to look primarily at financial measures in buying businesses and buying things that were cheap in relation to book value, and we always tried to get a lot of tangible assets in relation to our money.
But we found out that the intangible assets, if properly nourished and if properly identified, you can make a whole lot more money with than buying a lot of tangible assets cheap. And in 1972 - early in '72, Charlie and I went to See's Candy, which had been in the hands of the See family for many decades, and we bought it.
And, of course, Charlie and I didn't know a thing about making candy - we were pretty good at eating it - and we needed someone to run the place. We met a young fellow there. It was clear to both of us that he was the ideal person to run See's Candy, and in just a few minutes we made a deal with him that's lasted a lifetime.'
What to look for then?
Now that book value has got the boot from the world's greatest investor, which metric should you then look at while looking for your next investment? Here's Buffett telling what you should look for. 'We do look at what a company is able to earn on invested assets and what it can earn on incremental invested assets. But the book value, we do not give a thought to.'
Something to think about
The table below lists out some low price-to-book stocks in the Nifty 500 Index. Take a look at the names and their price-to-book ratios and ask yourself if any of these companies offer value at these prices? Are the issues that they face make them deserve their low valuations? Also, would you be comfortable holding any of them with a 10-year lock-in?