The fading usefulness of book value

Book value

Ain’t what it used to be

Something over 80% of the market capitalization of the S&P 500 is made up of intangibles. Only a fraction of that appears on balance sheets.

The rub is that investors rely on the book value of equity on balance sheets to assess the financial strength of a company (debt equity ratio), the value of shares (price to book value ratio), profitability (return on equity and return on capital). But, the world has changed. The usefulness of book value has faded. How so?

Forty years ago companies invested in tangible assets like plant and equipment. They also invested in intangibles. But, investment in intangibles was a small fraction of the investment in tangibles. Today, corporate investment in intangibles greatly exceeds that in tangibles. And, it’s not just technology and service sector companies. Almost every sector, including industrials, are investing heavily in intangibles. But, and here’s the problem, much of the intangible investment that creates intangible assets of lasting value never appears on balance sheets. That’s because much of this investment is never capitalized.

Even so, two factors have combined to produce a situation where today, intangible assets represent more than fifty percent of the book value of corporations, compared with less than ten percent forty years ago. First, the majority of corporate investment today is in intangible assets rather than tangible assets. Second, acquisitive companies are bulking up on accounting goodwill.

In the old days, when a corporation acquired another, the price in excess of book value was treated on the corporation’s balance sheet as accounting goodwill, an intangible. But, it was amortized. Nowadays, accounting goodwill is not amortized but is tested annually for impairment.

The modern company is becoming intangible and it very often doesn’t appear on the balance sheet. This means many properly priced public companies are trading at significant multiples of price to book value ratio.

A further thought – a low price to book value ratio does not necessarily mean a company is cheaply priced. It never has, even in the old days. Penn Central which was, at the time, the largest corporate bankruptcy in American history, had a book value of $60 per share when it declared bankruptcy. A high price to book value ratio does not mean a company is overpriced. I hasten to add that a high price to book value ratio may indeed be a sign of an overpriced stock. It all depends.

Want to read more about the issues raised in this post take a look at Chapter 35. Capital Structure, Strength and Economic Performance and specifically Sections 35.03 Book value of equity, 35.04 Accounting treatment of intangibles, 35.05 Accounting Goodwill and Economic Goodwill and 35.07 Understated tangible assets.

As for the impact on reported earnings on investment in intangibles see Sections 35.20 Impact of expensing intangible investments, 39.13 Earnings and investment in intangibles and 39.14 Price to free cash flow ratio.

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