Book value
Book value is a metric that a lot of people have historically used to value companies, and even today its a metric that is heavily used in specific sectors.
Let’s talk about that.
What is Book Value?
According to Investopedia, Book Value is:
The book value of a company is the net difference between that company's total assets and total liabilities, where book value reflects the total value of a company's assets that shareholders of that company would receive if the company were to be liquidated.
In many ways you can think of it as the assets that the company owns after paying off any debts it may have.
Usually the book value is not super useful, since for an operating company its earnings power is usually more important.
Even in cases where you’re talking about a failing company that is getting wound down, the book value might not be too useful either.
After all, just because you’re carrying that factory on the books at 100 million dollars, doesn’t mean that you’ll be able to sell it off for that much.
Many of the assets that companies own, and that are counted towards book value, are not worth as much to other businesses, and even in the cases where they are generally considered worth that much, it can be difficult to find enough liquidity in a short enough period of time to be able to sell them off at close to their value on the balance sheet.
Illiquidity is a real thing, and when it comes to a “firesale” that can severely hamper your ability to convert those assets to cash.
This is an even bigger problem when you don’t have tangible assets to sell!
How much is the brand on Coca Cola worth?
It’s difficult to say really, and if a company were to buy Coca Cola, and put its assets on the balance sheet, it would have a significant Goodwill component whose ability to convert into cash is… iffy.
Why is it useful?
Of course just because book value on its own isn’t always useful, that doesn’t mean there aren’t cases where book value can be a somewhat reliable method of evaluating a businesses value.
There are however a few “preconditions” for such a valuation:
The companies assets must be highly liquid
The companies assets should be primarily tangible assets
The companies business should be a “pass-through” business
There are generally few companies that fullfill all 3 of these requirements, hence why it’s usually not super useful.
That said, if you were to have a company whose primary business is to re-sell and distribute Coca Cola bottles in a given geographic area, and whose assets are primary the bottles they have in their warehouses, and the standard vehicles they use to distribute them, then you can have the book value be a fairly reliable metric here.
You have the high liquidity and tangibility of the assets (both Coca Cola Bottles, and distribution vehicles are fairly easy to sell quickly to other businesses), and the business itself is fairly “pass-through” (anyone can easily set up shop and do the same thing with the same assets).
This sort of business can be common in certain sectors, particularly the insurance sector.
Why the insurance sector?
If you think about it, insurance is primarily a financial business. You have collect premiums which you use to acquire assets and get a return from those assets.
Whatever claims you get should generally track the premiums you receive, and anything extra should come from the assets returns.
In effect, insurers are merely aggregators of risk, with the assets bought from the premiums being a way to pay their claims and get a return.
Since financial assets are generally highly liquid, and those assets are already fairly tangible (mostly they are cash, equivalents or securities), they almost always fullfill all 3 conditions.
That’s why insurers are almost always valued on their book value, though of course there are some exceptions when the quality of the assets is at stake, or when the risks in the liabilities are mis-stated.
Conclusion
The book value is a useful metric for certain types of businesses, and as a general rule it’s difficult to go wrong when buying businesses trading at below book value.
That said, it’s important to beware of incorrect book values that may give investors and the company a biased view of the health of a business.
What other metrics do you use to judge a company?
Let me know in the comments below!