Book values

Financial statements can be deceptive in many ways. One of the most deceptive is the "book value" derived from financial statements. This is particularly so because a lot of "pundits" give it credence and it is used in many ratios to "evaluate" investments and is very popular with data miners.

Except in the case of a small minority of companies like property companies and investment trusts that are asset based, book values bear little or no relationship to true values of the companies. The items on the balance sheet are the result of various transactions, recorded using double entry at a particular point in time, to the extent that they do not form part of the profit and loss account to that point in time. The assets and liabilities comprising the book value are mainly stated at historic cost though a few items therein may be stated at valuations.

In many of today's companies, their most valuable assets are not shown on the balances sheet and are therefore not included in the book value. Book values are meaningless in companies such as Apple, Microsoft, Facebook, Google, GlaxoSmithKline, etc where their intellectual capital, internally generated goodwill, etc are much more valuable than the assets per their balance sheets but are not included therein.

In Benjamin Graham's days, book values were more relevant as most companies then had significant investments in tangible assets and such assets comprised the bulk of the value of the company. The value of today's companies, other than asset based companies like investment trusts and property companies, is very different from the book values and there is no relationship between their intrinsic values and their book values. That is why Warren Buffet said "In all cases, what is clear is that book value is meaningless as an indicator of value" in his 2000 annual report.

I had discussed this in more detail, in 1998, on Motley Fool's BB - see http://boards.fool.co.uk/Message.asp?mid=5677919&sort=whole. Some points from this:

  1. "Gearing", "ROCE", and other ratios that are calculated with reference to book values are irrelevant for investment decisions though many "pundits" extol their importance. They are irrelevant because, with a few exceptions such as investment trusts and property companies, the book values have little relation to the real values of companies.
  2. It is not the "high" debt that is irrelevant. Obviously, all other things being equal, a company with high debt is more risky than one with a lower debt. It is when gearing is measured with respect to a meaningless book "value" that "gearing", so calculated, becomes irrelevant. If you calculate a meaningless ratio, you will make wrong investment decisions rejecting companies which have acceptable levels of risk and high potential.
  3. The company's real value becomes more and more remote from the book value per the balance sheet over the long run.
  4. The objective of the balance sheet should be to show the financial condition (not the value) of the business at the date the balance sheet is drawn up. To what extent this objective is met is debatable. In practice, the balance sheet items are the net result of various transactions recorded using double entry that are not part of the profit and loss accounts up to a particular point in time and are carried forward to future accounting periods at that point in time.
  5. It is usually possible to get a useful idea of the financial condition of the business by careful study of the balance sheet in conjunction with the accounting policies and the notes. But the figures can be deceptive and, unless the investor has a good understanding of how the figures are compiled, he may arrive at the wrong conclusions. Some of the figures are more useful (e.g. trade debtors) than others (e.g. plant & machinery), some are misleading (e.g. reserves), some valuable assets (e.g. intangible assets such as customer goodwill built up internally) are not included in the balance sheet at all, sometimes transactions (e.g. sale and leaseback) are conducted to make the financial condition look better than it really is, some figures (e.g. bank balances) are more precise than other (e.g stocks) and I could go on and on and on...
  6. I am not arguing that ROCE is not an important ratio. What I am saying is that ROCE calculated based on "book values" is irrelevant and leads to wrong investment decisions because "book values" bear little or no resemblance to the true capital employed. It is not possible to calculate the true ROCE based on the figures in the published accounts. Competent finance directors generally use more sophisticated methods such as DCF and risk analysis techniques to appraise major capital expenditure projects and acquisitions and apply hurdle rates above the company's cost of capital. When they use ROCE, they calculate it using relevant internal information not available in the published accounts.