How to avoid being misled by book value when evaluating a company’s value

Warren Buffett has repeatedly reminded investors that book value is often a poor measure of a business.

The calculation itself is simple: take total assets minus liabilities. But book value, Buffett says, often distorts reality, whether by overestimating or underestimating a company’s true value.

Over the years, Buffett has written about the shortcomings of using book value per share (BVPS) to value Berkshire Hathaway. As president of the company, Buffett preferred to focus on the company’s intrinsic value instead.

Buffett: Book value is a limited tool

Warren Buffett believes that book value, although an easily calculated number, is of limited utility. For companies where Berkshire Hathaway has full control, for example, the book value of those assets on the balance sheet can be very different from the companies’ true intrinsic value.

Buffett described how Berkshire’s book value per share in 1964 was $19.46, but the company’s intrinsic value at the time was much lower because the company’s textile assets were less than their stated value.

Moving forward to December 2001, the book value per share rose to approximately $38,000, and nearly $100,000 by December 2011. However, these numbers actually I reduced The intrinsic value of the company, with the P/B ratio declining from approximately 2.0 to 1.15 over the same 10 years. As Buffett noted, most of Berkshire Hathaway’s core companies “were worth much more than their book value.”

Moral of the story: Book value can be misleading in both directions. It can overestimate or underestimate the true value of a business.

Book value versus intrinsic value versus market price

• Intrinsic value It is “the discounted value of cash that can be taken from the company during its remaining life.” This is an estimate and is therefore subjective and sensitive to both interest rates and future cash flow assumptions. Buffett says this is the only rationale for the valuation.
• The value of the book It is an accounting measure and is not a reflection of the true economic value of a company. At Berkshire Hathaway, Buffett only uses the change in book value per share as a rough proxy for tracking changes in intrinsic value, but he cautions investors not to confuse the two.
• Market price It is the third number that can get in the way, as it often reflects short-term market sentiment more than anything else.

Buffett’s way of doing business

“[B]“Companies are logically worth much more than net tangible assets when they are expected to earn profits on those assets…” Buffett wrote. He prefers to measure the “economic” performance of any company, which is a much better performance than tracking its book value or even its earnings per share.

To illustrate his point, Buffett used the analogy of a college education. The tuition paid, lost income, and experience while attending school is the “book value.” However, the relevant value is the present value of the additional lifetime earnings that this degree makes possible. For some, the intrinsic value (i.e. the economic return) is greater than the price (cost). For others, it is not. This analogy underscores his general point: focusing on intrinsic value rather than cosmetic accounting. In either case, the concept of book value has no real use in evaluating an individual’s professional value creation.

Bottom line

Book value is a bad way to judge a business, according to Buffett. As an accounting number, it can sometimes serve as a trend indicator but can be misleading. It may overstate the value of distressed assets, for example, but it may easily underestimate the value of companies that have intangible assets that are difficult to account for. Buffett says the best guide to a business’s value is its intrinsic value. Although difficult to calculate, it is rooted in the value of future cash flows.