For decades, value investors have used book value per share as a tool to gauge a stock’s potential value.
This approach started with Benjamin Graham. Widely considered the father of value investing, Graham taught his students that all stocks trading below book value were attractive investments because companies offered a wide margin of safety and a low level of risk. To this day, many value investors rely on book value as a shortcut to calculating value.
Buffett on book value
Warren Buffett (trades, portfolio) is perhaps Graham’s best-known student. For years, Buffett has used book value, among other measures, to gauge a company’s net worth. He also used book value growth as a yardstick to calculate Berkshire Hathaway’s (NYSE:BRK.A) (NYSE:BRK.B) value creation.
However, as early as 2000, the Oracle of Omaha began to drift away from book value. He explained why at Berkshire’s annual meeting of shareholders in 2000. Responding to a shareholder who asked his opinion on using book value to track changes in intrinsic value, Buffett replied:
“The best companies, the really wonderful companies, don’t require any book value. They – and we are – we really want to buy companies that will provide more and more cash and won’t need to hold cash, which builds increase book value over time…
In our case, when we started with Berkshire, the intrinsic value was less than the book value. Our company wasn’t worth book value at the beginning of 1965. You couldn’t have sold the assets at the price they were on the books, you couldn’t — nobody could make a calculation, in terms of future cash flows that indicate that these assets were worth their carrying value. However, it is true that our companies are worth much more than their book value. And this happened gradually over time. So obviously there were a number of years where our intrinsic value exceeded our book value to get to where we are today…
Whether it’s the Washington Post, Coca-Cola or Gillette. This is a factor that we ignore. We look at what a business can earn on invested assets and what it can earn on additional invested assets. But the book value, we don’t think about it.”
It’s no secret that value as an investment style has underperformed growth over the past decade. There is no obvious explanation as to why this is the case, but one of the explanations could be that the definition of value is outdated. Buffett’s comments at the 2000 annual meeting seem to support this conclusion.
It’s no longer a good measure
Book value was an excellent proxy for value when companies relied on large asset bases to generate profits. As the economy has moved away from asset-intensive businesses and towards more knowledge-intensive businesses, book value has become less and less relevant.
Also, as Buffett explained in 2000, book value does not necessarily represent intrinsic value. Just because a stock is trading below its book value does not necessarily mean it is worth said book value.
The same goes for companies that trade with a premium to book. The intrinsic value of this business could be significantly higher than the book value, as the book value does not generally reflect intangible assets.
Investing is an art, not a science, and valuing companies is not a simple process. Investors cannot rely on a simple metric or shorthand to gauge value. Many factors contribute to intrinsic value and the growth of intrinsic value, and using book value as a proxy for intrinsic value is an outdated method. Even in Graham’s day, that wasn’t always correct.
Disclosure: The author owns stock in Berkshire Hathaway.
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This article first appeared on GuruFocus.