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Book value: Weighing on assets - Views on News from Equitymaster
 
 
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  • May 21, 2002

    Book value: Weighing on assets

    In general, we can assume a company’s share price to be the sum of two components. The first component is the price assuming that the company does not grow in the future. The remaining part would be derived from expectations of growth in earnings going forward, the present value of future growth opportunities.

    For high growth sectors, a significant component of the stock price would be a function of the future growth expectations, while for the not so rapidly growing sectors the markets would look at other options for determining the stock price. And the assets a company holds is a good place to start. Stocks that derive a large part of the price from future growth prospects are known as growth stocks. (Read more). This article is focused on the theoretical aspects of book value and how to put a price to a stock using the book value.

    The difference between assets and liabilities gives net worth of the company. Net worth is that part of business, which belongs to the common shareholders (the owners). Net worth per share of the company is known as book value.

    So what does book value tell us? Firstly, it is the value received by the shareholders on the sale of company’s assets at prices mentioned in the balance sheet. Since the value is determined from accounting journals its is known as book value. Also, book is an approximate indicator of the ‘inherent value’ in a stock price and can therefore be assumed to be the no growth component of the stock price. This is what makes the number so useful. For low growth industries or when a company is passing through a period of low (or negative) growth the book value can be used as an indicator of the stock price or a floor for the stock price.

    Industries like banking, manufacturing and automobiles are basically asset intensive in nature and therefore, looking at book value as a tool for making investment decision makes good sense. While book value is a good tool to determine stock price for such industries, there is a word of caution. Assets include land, buildings and inventory amongst other things. The valuation, as per accounting standards for these assets could be vastly different from their real market value. The real market price, of the assets, could be much higher or lower.

    Consider Indian Hotels Company (IHCL), the company’s prime property in South Mumbai is much more valuable than that shown in the books due to the fact that building has been fully deprecated and is carried on the books for almost no value. The book value grossly understates the sell-off value of the company. On the other hand, consider the IT companies with old computers. The computers are not of much of value on resale. Here the book value overstates the sell-off value.

    While using book value makes sense for certain industries, for other it does not. It does not make sense to use book value for services and FMCG industries not advisable. This is due to the simple fact that stock price contains a significant proportion of growth component. Let us take a look at a few examples.

      Networth
    (Rs m)
    No of
    Shares (m)
    BVPS (Rs) CMP (Rs) BV/P (%) P/BV (x)
    L&T 39,599 249 159 181 87.9% 1.1
    SBI 134,615 526 256 220 116.5% 0.9
    HLL 24,882 2,201 11 203 5.6% 18.0
    Infosys* 20,803 66 314 3,819 8.2% 12.2
    Telco 32,538 256 127 138 92.2% 1.1

    *As per FY02 balance sheet; All others numbers from FY01 balance sheet

    L&T’s book value for the year-end March 2001 is Rs 159. Thus, approximately 88% of the current market price is based on the assets the company has. For SBI the book value is Rs 256 and the stock price of is Rs 220. This translates to the fact that the markets are valuing the bank lower than its book value. However, there is a catch. SBI had net NPAs (Non Performing Assets) of Rs 68 bn in FY01. NPAs are loans given out by the bank that have gone bad. Though the amount of Rs 68 bn is owed to SBI by various borrowers, and theoretically is an asset, it is unlikely that the bank will recover most of the money. Thus, if we exclude the NPAs from the banks net worth, the book value works to be Rs 125. In this case the book value supports around 57% of the current market price. Similarly, for Telco the book value supports 92% of the stock price.

    Let us take the case for HLL and Infosys. While HLL’ stock price is Rs 204, the book value works out to be only, Rs 11. Similarly in the case of Infosys, the book value works out to be Rs 314 and the stock price is Rs 3,819. Thus, the book value accounts for 5% and 8% of the stock price for HLL and Infosys respectively.

    This variation in the price of Infosys and HLL is due to the fact that these companies don’t need to have significant amount of assets for their business. Their most valuable assets, intellectual capital and brands, are intangible in nature. Consequently, it is very difficult to put a price to these intangibles. This make valuation of the company’s very subjective. Incase of an unfortunate event the price of these stocks can erode rapidly.

    (Rs m) Total
    Assets
    Fixed
    Assets
    Sales Sales/
    Total Assets (x)
    Sales/
    Fixed Assets (x)
    L&T 108,205 46,710 73,787 0.7 1.6
    SBI 2,615,050 25,933 300,212 0.1 11.6
    HLL 57,345 12,035 106,038 1.8 8.8
    Infosys* 25,397 5,577 26,036 1.0 4.7
    Telco 79,766 38,236 68,036 0.9 1.8

    *As per FY02 balance sheet; All others numbers from FY01 balance sheet

    This is evident from the fact that Infosys and HLL have sales at 1x and 1.8x times their assets. The number is low for Infosys as it holds a significant amount in cash and investments. Considering only net fixed assets (NFAs), the sales work out to be 9x and 5x the fixed assets for Infosys and HLL respectively. The Sales/NFA for SBI works out to be very high 12x, as banking business requires low fixed assets. However, the Sales/Asset for SBI is 0.1x. This is because the business requires significant amount of advances and investments.

    Price/book value

    A very interesting ratio emerges by the comparison of the market price (market valuation) to the book value (accounting value of assets less liabilities). While one measures the earnings power the other reflects the part of price backed by assets. A market-to-book ratio of about 1.5 times is that the firm is worth 50% more than what past and present share holders have put into it. The ratio indicates what kind of a price investors are willing to pay for Rs 1 of book value of the stock.

    The price to book value for a stock can be calculated using,
    We know that price of a stock (P),

           D
    P =   ----
          r-g
    
    

    Where
    D = Expected value of dividends next year
    r = Required return on equity (Read more)
    g = perpetual growth rate of equities
    Now substituting dividends by Earnings Per Share (EPS)* Payout Ratio

    
          EPS * Payout Ratio* (1+g)
    P =  ---------------------
                 r-g
    
    

    The EPS can be written as the Book Value (BV) * ROE (Return on Equity)

    
          BV* ROE * Payout Ratio* (1+g)
    P =   -----------------------------
                    r-g
    Thus, 
     P      ROE * Payout Ratio* (1+g)
    --- =  --------------------------
    BV              r-g
    
    

    The bank rate (at interest rate at which SBI borrows from the RBI) is 6.5%. SBI’s beta is 1.04 and market risk premium is assumed to be 7%. Therefore, the cost of equity ( r ) for the bank works out to be 13.8%.

    Further, SBI had a ROE of 16% in FY01, the payout ratio was 12.9% and the dividends were expected to grow at CAGR of 9% for the next five years. Thus, substituting the values in the equation we get the theoretical P/BV for SBI should be 0.6. Currently, SBI trades at 0.9x its book value. Once the P/BV is determined by using the equation, using the BV the price can be easily determined.

    Thus, calculating the theoretical price to book value should give an idea about the fair value of the stock. However, the investment decision cannot be made on this ratio alone. Other qualitative and quantitative factors have to been taken into consideration. The Price/Book Value is useful when evaluating banks. This is because there the difference between the market value of the loans and their book value is likely to be very less.

    A study of the valuation of three majors one from the automotive sector (Telco), one from the banking sector (SBI) and one company with diversified business interests (L&T) indicates that P/BV of 1x serves as a good measure of floor price of the stock price. In the period between 1994-1998 not one of the three stocks mentioned traded below a 1x its book value.

    However, post 1999 many things changed. Firstly, the markets as a whole took fancy to ‘new economy’ and old economy stocks like Telco, L&T and SBI were no longer in favour. Also, Telco ventured into its car project and the company posted losses. However, since third quarter of FY02, Telco car Indica started toppling the sales charts. SBI as we mentioned before has NPAs to the tune of Rs 68 bn.

    However, a trend that is evident for all the three stocks is that the P/BV has declined over a period of time. This can be explained on a case-to-case basis. SBI has seen a sharp decline in its payout ratio during the period. L&T on the other hand has seen the ROE decline steadily. However, the effect of the decline in ROE has been offset to some extent by an improvement in the payout ratio.

    While value stocks do not offer swift gains, but they are not prone to rapid erosion in value either. This makes them excellent candidates for a retail investor’s portfolio. Knowing how to price them will certainly help. L&T for all its value does not seem a good buy at a P/BV value of 4x.

     

     

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