- Book value might be the biggest not risk, but loss of value in the current market environment.
- A full year of S&P 500 earnings evaporates every 3.5 years.
- Fortunately, there is something you can do.
Today, I’ll continue with my series on market risks. These are the main market risks I see and you can read more about them by clicking on the links provided:
- Debt is being used recklessly.
- Valuations don’t matter as growth is the key and profitability will come.
- Book values are so old fashioned.
- Stocks can only go up and corrections and bear markets don’t last long.
- If you invest in index funds, you will do well.
In this article, I’ll focus on book values which are often an omitted metric, especially late into a bull market, but are extremely important.
Book Values are so important that the metric is Buffett’s favorite for performance, or the change in book value, not so much the actual book value. But more about that later.
If you’re always increasing the book value you own, you will do great as an investor. Let me first briefly explain how book value works, then we’ll dig into the current market’s book value, and conclude with a discussion about the various views on book values and three things you can do about it from your portfolio perspective.
How Book Value Works
Book value is an accounting concept and it usually significantly differs from intrinsic value. Buffett’s favorite way of explaining this by using the two brothers story. If parents spent the same amount on their kids’ educations, the book value of them would be the same. However, the intrinsic value of that same-cost education might be zero in one case and a thousand times the cost in the other case. So if intrinsic value is the key when investing, why would I worry about book values?
Further, there are many issues with book values. A company might have spent $7 billion on oil exploration in the Arctic, but if it needs oil prices to be above $100 for it to be profitable, the actual value could be zero. Also, there is a big difference between tangible book values and intangible book value, or goodwill, which is another accounting concept and nothing more than that.
Going back to Buffett, the key measure when investing is to look at the change in book value because that’s the only objective way to measure intrinsic value. The change in book value in a year tells you exactly how much the intrinsic value has changed over the same year. When you pile those things up over half a century, you get Buffett’s results.
As you can see above, BRK’s annual change in book value almost equals the return on investment achieved by Buffett with 19.1% vs. 20.9%. That will probably even out in the next cycle. So the risk isn’t that much in actual book values but in the creation of them, and here is where corporate management often strays which creates another significant risk for some stocks.
Current Book Value Issues With Stocks
If we take a look at the book value of the S&P 500, there’s nothing concerning about it, it is growing at a fast pace.
However, if you look at it a bit closer you’ll see that the situation isn’t that stellar as there is a lot of value that disappears.
The difference between earnings and actual book values is staggering. However, to properly approach the matter, I have to add the S&P 500 dividends to the change in the book value and compare that to the earnings. Then there should be no difference between the metrics because the change in book value should equal the increase in earnings minus the dividend.
When I include the dividends, the difference is much smaller but there is still a difference and the discrepancy has been bigger in the last few years. A table will be a better representation of what is going on.
So over the last 19 years, 326 points of book value in the S&P 500 has disappeared, or 40.8% of the current S&P 500 book value. Where did that value go? It went into buybacks, which are mostly only sometimes a good thing, and other dilutive practices that don’t really create shareholder value.
In the last 4 years, the value that has disappeared thanks to buybacks was 136 S&P 500 points which is much more than the S&P 500’s current earnings at 107 points. I wonder whether someday someone will wake up and ask where this value has gone. Perhaps the reason no one has is that there are various perceptions on book values in the current market.
Various Views On Book Values
One is Buffett’s measure, and that is also his measure for performance. However, in the current environment, most focus on stock prices. As long as prices increase, book value doesn’t matter.
The problem is that when earnings contract, the paper values stocks have gained in the last few years thanks to corporate buybacks quickly evaporate while the destroyed book value is gone forever with the one who sold the share to the company in the first place. The key is that a company needs the book value to create future earnings and to have somewhere to invest and rebuild itself. This might sound crazy in this market with huge market capitalizations based on average monthly users metrics or revenue growth, but at the end of the day, it all boils down to the actual value that has been created. It isn’t for nothing that Buffett uses it as his main measure.
What You Can Do
There are three things that you can do. The first is that you start measuring your portfolio success by how much book value has been created over a year and not by the stock market value of it.
Secondly, if you own a company that is aggressively buying back its stock to temporarily increase earnings, you might actually want to sell it to the company at this point in the market cycle.
Thirdly, you might avoid investing in companies where the current buybacks will clearly destroy long term value. Those companies have high current earnings and high stock prices but their businesses are of a cyclical nature which means that there will be periods where earnings are zero or negative. When that happens, book value will matter, so be sure to look at the quality and sustainability of current earnings.