Should We Look at Book Value?

Is book value an important consideration for you before you invest in a company or do you focus more on the earnings and the potential of the company? While I think that earnings and the potential for the growth of the company are important (maybe most important), but we should also take book value into consideration

(Image source: flickr.com)

I think that book value is important as it acts as a form of safety for the investor in case the company fails. For book value to act as a form of safety, we also have to look at the quality of the assets of the given company. Cash is king, while other assets such as inventory and PP&E may have to be sold at a price much lower than their book value if the company is liquidated. To find out more about the assets and liabilities that the company has, we should look at their balance sheet, which would also give us the total equity of the company (its book value).

Other than acting as a form of safety, book value is also important when we calculate the return on equity for the company. For the same amount of earnings, less equity would mean a higher return on equity. A high return on equity can be good as money put into the company, whether through retained earnings, rights issues, etc, would supposedly be able to earn the same high return for the investor. However, this leads to the question on whether the company is able to maintain the high return on equity. The company needs a competitive advantage, a moat, in order to maintain high returns on equity above the market average over the long term and unless it has this, the company should have a sufficient amount of book value to continue generate good returns for the price you are paying for it.

There are many examples of companies that are able to do well despite having a high price to book value ratio. This group includes telecoms (at least in Singapore) such as M1 and Starhub and web companies such as Facebook. These are able to generate good returns on equity for their investors and are able to justify the high price, but I would prefer to steer clear of them. This is more of a personal sentiment I guess, but I would like to have a margin of safety to fall back on in case things don't go as planned and I find some safety in the book value of the firm (taking the inventory, PP&E and intangible assets with a pinch of salt)

While I consider book value before investing in a firm, I wouldn't choose a company simply because it has a very low price to book value. Usually these companies have their own host of problems that lead to a low price to book value in the first place, so I'll look into the firm carefully before investing in it.

I guess I would consider a company that has good earnings, potential for growth and selling at a low price even if the book value is low, but how often do we come across these types of companies? If they meet the first 2 criteria they will usually fail on the last or the potential entails a high level of risk. But if we're investing in a company with a high price to book value, I think we shouldn't put in too many of our eggs into that basket to avoid getting burnt if things fail and there's no margin of safety to fall back on.

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