Using Book Value to Decide Whether to Invest

With stocks at record heights, bulls and bears alike are straining mightily to defend their respective positions. If you want to start a fist-fight between the two camps, mention “book value.”

A company’s book value is its theoretical liquidation value--that is, the sum that would be left for shareholders if all the assets were sold and all the bills paid off. It’s essentially the net worth of the company.

Thus, one way to measure how high-priced the stock market has become is to look at the average stock’s price relative to average book value per share.

The price-to-book measure is typically expressed as a ratio. If a stock is priced at $10, and the company’s book value is figured at $10 a share, the stock sells for 1.0 times book. If the stock is at $20 and book is $10, the ratio is 2.0. And so on.

In theory, the more you pay relative to book value, the greater the risk, because you’re “buying” assets that aren’t there.

As stock prices have soared in recent years, the price-to-book ratio of the Standard & Poor’s index of 400 major industrial companies has risen dramatically: From 1.3 in 1982 to 2.1 by 1987, to the current 2.97.

In fact, today’s price-to-book ratio is higher than at virtually any point in modern history. The only other times that stocks have sold for nearly three times book value were brief periods in 1928 and 1987--just before the two greatest stock crashes of the century. No wonder the bears are adamant that prices are peaking.

How do the bulls defend paying 2.97 times book? They can offer only one argument: Book isn’t what it used to be--it’s better. So you’re really not paying as much as it seems.

Money manager Charles Brandes at Brandes Investment Management in San Diego figures it this way: The price-to-book ratio was low in the 1970s partly because “a lot of what companies carried as ‘book value’ in the past wasn’t real.”

Look at the number of plants closed, assets sold and restructuring charges incurred by major American companies in the 1980s, Brandes says. In that decade, companies took the assets that weren’t producing and wrote them off or streamlined them. Either way, the value of the assets on many companies’ balance sheets was clipped to reflect what those buildings and machines were truly worth.

That caused book value to decline at many companies. But what was left on the balance sheet was the real thing--productive assets that would generate a far better rate of return.

Likewise, the writeoffs of the ‘80s obliterated the inflation premium that was pumped into book value in the ‘70s, says Arnold Kaufman, Standard & Poor’s investment strategist in New York. As inflation raged in the ‘70s, it artificially boosted the value of corporate assets (both productive and unproductive assets).

So if a company had a bloated book value of $10 a share in 1977 and its stock was at $15, the price-to-book ratio appeared to be a mere 1.5. But if the truly productive assets were worth just $5 a share, the real price-to-book ratio in 1977 would have been 3.0, no different than today’s.

That’s a simplistic example, of course, and there’s no way to go back and measure how all corporate assets should have been valued in the 1970s or in previous decades. But the bulls’ point is that stocks today aren’t so outrageously priced as they might seem. So you shouldn’t be afraid to buy--especially at the early stage of an economic recovery, the bulls say.

To the bears, the book-is-better argument is ridiculous. Inflation happens on and off through history, and so do corporate writeoffs and restructurings, the bears say. Yet isn’t it amazing, they note, that the price-to-book ratio of the largest companies rarely stays above the 2.0 level for very long?

“This tendency to ignore time-tested indicators is a clear symptom of a stock market top,” contends Charles LaLoggia, editor of the Special Situation Report market newsletter in Rochester, N.Y., and a long-time bear.

“Every stock market top creates a willingness among analysts and investors to stretch the concept of value, a desire to believe that for some reason the value indicators which have defined stock market tops in the past can be ignored, just this one time,” LaLoggia says. “Of course, values will ultimately prevail.”

It’s also true, though, that price-to-book ratios can come down in one of two ways: Either stock prices fall, or book value rises.

How does a company boost book value in the 1990s? Getting rid of debt is one way, because that leaves more equity for shareholders.

And in fact, that is exactly what many companies are doing: They’re selling new stock, or selling assets, to pay off the heavy debts incurred in the 1980s.

A company also can raise book value the old-fashioned way--by earning more money and reinvesting it in new producing assets for the business.

Profits have been relatively scarce this year, of course, with the recession. But if the global economy improves next year as expected, and corporate profits rise, book value figures will improve.

James Moltz, investment strategist at brokerage C. J. Lawrence Inc. in New York, argues that even with the drop in profits at many major companies this year, the typical corporate return on equity is high enough to keep him invested in stocks.

Think of it this way: A company’s return on equity measures net income as a percentage of the company’s net worth. That simply tells you how effectively a company is putting shareholders’ money to work. If a company can’t do better for you than what a bank CD pays, it doesn’t make much sense to be invested in the stock.

Moltz figures that the annualized return on equity for the S&P; stock index this year will run in the 13% to 14% range. Next year, it may get up to 16% with the economy’s recovery, he says.

A 16% return, minus inflation of 5% (assuming it stays that low), would be a real return of 11% on shareholders’ equity in 1992. In the ‘70s and early ‘80s, with higher inflation, the real return on shareholders’ equity was more typically around 8%, Moltz says.

His conclusion: “Today isn’t a bad time to own a business.”

If investors are thinking that way, and looking with hope to an unprecedented era of free markets worldwide in the ‘90s, they may be content to continue to pay what appear to be high price-to-book ratios.

That doesn’t mean that stocks will quickly go to the moon from here. But, remember the pattern of most of the ‘80s: Stocks repeatedly soared, stalled for extended periods, then soared again, as profits caught up with expectations.

Stock Prices Versus “Their Book” Value If Company X’s assets would be worth $10 a share to shareholders if it were liquidated today, how much should you be willing to pay for the stock? That’s a constant debate on Wall Street. Generally, the more optimistic people are about future growth of assets, the more they’ll pay relative to the current liquidation, or “book” value. Right now, the ratio of stock prices to their book value is 2.97, the highest ratio since 1928. * Ratio of Standard & Poor’s 400 industrial stock index to companies’ book value (annual average, except latest) Source: Ned Davis Research