Digging into book value

In the corporate security investor food chain, equity investors don’t get the first shot at operating profits. Common shareholders get what’s left after the company pays its creditors, preferred shareholders, and the tax man. But in the world of investing, being last in line can often be the best place, and the common shareholder’s lot can be the biggest slice of the profit pie. Read on to find out how to get your cake and eat it too.

While corporate debt holders and preferred stockholders are entitled to a set series of cash payments, excess cash flow is owned substantially by common stockholders. In theory, if the common shareholders decide by a majority vote to close the company, they would be entitled to whatever is left after they settle the debtors’ and preferred shareholders’ claims. The value of a common share is therefore related to the monetary value of the common shareholders’ residual interest in the company – the net asset value or share capital of the company.

Measuring the value of a claim
A good measure of the value of a shareholder’s outstanding debt at any given point in time is the book value of equity per share (BVPS). Book value is the book value of the company’s assets less any claims that outweigh the common stock (e.g. the company’s liabilities).

In simple terms, it is also the original value of common shares issued plus retained earnings, less dividends and share repurchases. BVPS is the book value of the company divided by the company’s issued and outstanding common shares.

Stock investors often compare the BVPS to the market price of the stock in the form of the market price/BVPS ratio to give shares a measure of relative value. Keep in mind that book value and BVPS don’t take into account the future prospects of the company – they’re just snapshots of the common equity claim at a given point in time. Going concern is whether a company should always trade at a price/BVPS ratio greater than 1 when the market is a proper reflection of the company’s future prospects and the stock’s upside potential.

Why BVPS?
So why use BVPS as an analytical tool when it doesn’t fully measure the stock’s potential? There are a few good reasons:

1. BVPS is a good baseline for a stock. While not technically the same as the stock’s liquidation value, it is a proxy for it. In many cases, stocks can and do trade at or below book value. If the company’s balance sheet isn’t upside down and its business isn’t broken, a low price/BVPS ratio can be a good indicator of undervaluation.

2. BVPS is quick and easy to calculate. It can and should be used as a supplement to other valuation approaches such as the PE approach or discounted cash flow approaches. As with other multiple approaches, the price/BVPS trend can be evaluated over time or compared to multiples of similar companies to assess relative value.

3. If the company is going through a period of cyclical losses, it may not have positive trailing earnings or operating cash flows. Therefore, an alternative to the price-earnings approach can be used to determine the current value of the stock. This is especially true when the analyst has difficulty assessing the company’s future earnings prospects.

How to calculate BVPS The quickest way to calculate BVPS is to look at the equity section of a company’s balance sheet and think about what the common shareholder actually owns — outstanding common stock and retained earnings. The good news is that the number is clearly stated and does not usually need to be adjusted for analytical purposes. As long as the auditors have done a good job (and the company executives are not crooked), we can use the common equity measure for our analytical purposes.

For example, Walmart’s balance sheet as of January 31, 2012 shows that its equity is valued at $71.3 billion. The number is clearly shown as a subtotal in the equity portion of the balance sheet. To calculate BVPS, you need to find the number of shares outstanding, which is also usually found in parentheses next to the common stock label (at Yahoo! Finance, it’s in Key Statistics). What we’re looking for is the number of shares outstanding, not simply issued. The two numbers can be different, usually because the issuer has repurchased its own stock. In this case, the number of shares outstanding is 3.36 billion, so our BVPS number is $71.3 billion divided by 3.36 billion, which is $21.22. Each common share has a book value — or salvage value of the claim — of $21.22. When Walmart’s 10-K for 2012 came out, the stock was trading in the $61 range, so the P/BVPS multiple was about 2.9 times at the time.

make calculations practical Now it’s time to use the calculation for something. The first thing one could do is to compare the price/BVPS number to the historical trend. In this case, the company’s price/BVPS multiple appears to have been slipping for several years. A good analyst would want to know why. A moving price/BVPS multiple may not indicate better relative value. Second, compare Walmart’s price/BVPS to similar companies. In this case, the stock appears to be trading at a multiple roughly in line with its peers. Given Walmart’s massive size, a premium may be warranted here.

An even better approach is to find a company’s tangible book value per share (TBVPS). Tangible book value is the same as book value except it excludes the value of intangible assets. Intangible assets like goodwill are assets that you cannot see or touch. Intangible assets have value, just not in the same way as tangible assets; You can’t just liquidate them. By calculating the tangible book value, we could get one step closer to the base value of the company. It’s also a useful benchmark for comparing a company with a lot of goodwill on its balance sheet versus one with no goodwill.

To calculate the tangible book value, we need to subtract the book value of the intangible assets from the share capital and then divide the result by the shares outstanding. Continuing with the Walmart example, the value of goodwill on the balance sheet is $20.6 billion (we assume the only intangible asset for this analysis is goodwill). The TBVPS is $15.01. The price/TBVPS ratio will be about 4x when Walmart’s 2012 10-K is released. Again, we want to examine the trend of the ratio over time and compare it to similar companies to gauge relative value.

The final result Using book value is one way to form an opinion about the value of common stock. Like other approaches, book value examines the shareholders’ share of the earnings pie. Unlike revenue or cash flow approaches, which are directly related to profitability, the book value method measures the value of the shareholder’s claim at a point in time. A stock investor can deepen their investment thesis by incorporating the book value approach into their analytical toolbox.