Buffett no longer relies on book value as a valuation metric.
Among the reasons stated:
- Book value does not reflect the current or market value of assets – it does not reflect the intrinsic value of the company
- Intrinsic value is a better metric for valuation
- Market prices are more relevant
To which I say “huh”!
With all due respect Warren, you are conflating and confusing multiple things here.
Let’s get back to the basics of classical value investing.
What Value Investors Really do with Book Value?
True, we are all guilty of taking price to book ratio at a superficial level to quickly value a stock.
However, a good value investor is not a superficial value investor. A good value investor understands and knows that the accounting book value as reported on the financials is not a clean number.
It contains assets that can be severely undervalued due to age and depreciation. Real estate that is carried at old values. Fully depreciated inventory that is still productive.
It contains assets that are not even counted properly as they are not tangible enough to place value on (R&D, patent portfolio, customer list, etc.)
It contains assets that may be severely overvalued and need to be written down or charged off. Perhaps investments gone bad.
The point is that us value investors are aware of these things, and we adjust for them. There are metrics such as tangible book value, net current asset value, etc. that take us closer to the real book value. We may adjust more depending on the specific situation of the company and our own industry knowledge.
So, Buffett is right that the accounting book value is not always relevant. He is wrong in suggesting we should abandon book value as a valuation metric or a basis to calculate the intrinsic value.
Intrinsic Value is a Better Metric for Valuation
True. No value investor will question this. The real problem is how do you arrive at the intrinsic value. Do you take the market price of the asset and declare that to be the intrinsic value of the asset?
If you do so, it is no longer value investing.
Value investing lives in the gap between the market price and the intrinsic value. Declare the gap to be irrelevant, and value investing ceases to exist.
Market prices are more relevant.
Now this is just being lazy.
Market prices are relevant to know the … market price of the asset.
One can argue that Buffett is talking about the market value of the owned assets of the company, that goes into calculating its intrinsic value.
He may not be talking about the market price of the stock itself.
I will rebut both these positions.
- Buffett may be suggesting that we take the market value of the owned assets of the company when we calculate the intrinsic value.
I am sure this is something a lot of investors struggle with. You do want to mark the owned assets to the market when you adjust the book value and calculate an intrinsic value number. However, we also know that marking to market makes sense in certain situations, and does not make sense in other situations. As value investors, we do have the tools to handle these different situations. There is a concept of liquidation value, that considers different scenarios of orderly or forced liquidations and estimates the value that can be received. Some assets can be exchanged at even value – for example, cash and cash equivalents, others may just end up getting scrap value, for example old machinery.
- He is indeed talking about the market price of the stock itself. This is evident when you consider the following statement
“In future tabulations of our financial results, we expect to focus on Berkshire’s market price. Markets can be extremely capricious: Just look at the 54-year history laid out on page 2. Over time, however, Berkshire’s stock price will provide the best measure of business performance”
So what is Buffett Really Saying Here?
He is saying that book value of Berkshire Hathaway is no longer going to be the metric they want to use to make decisions about the valuation of Berkshire Hathaway.
It is just his personal choice as a manager. Berkshire Hathaway has changed its portfolio from mostly equity investments to now mostly operating companies. Perhaps this change in how he looks at the Berkshire stock makes more sense to him.
It does not mean that book value is no longer relevant for value investing.
It also does not mean as investors we should look at Berkshire Hathaway valuation in the way Buffett chooses to do. We should feel free to ignore him and use that valuation methods that make more sense to us in judging Berkshire Hathaway or any other company. He is just being a manager and we choose to disagree with managers all the time.
What about the Changing Nature of the Business?
In older and simpler days, industry used to be full of heavy machinery and tangible assets. These assets had tangible values and were less mobile (or liquid). Which meant that the values are clearly defined and predictable. These assets also made up a significant part of the company’s balance sheet.
Today with technology and productivity powering most of the output, and service companies dominating the economy, companies are able to create more value of a smaller tangible asset base.
So average price to book ratios today are higher than they used to be.
Additionally, average price to book ratio for a tech company like Microsoft, will be much higher than, say, Ford Motor Company that still relies significantly on tangible assets to produce value. There is a variation between the industries and sectors.
Therefore, it follows that Return on Assets or Return on Equity is becoming a more important metric now, since it measures the value that the company is able to generate out of its asset base or equity.
As value investors, we do understand that the price to book ratios vary by the sector. The old guideline of buying stocks under a P/B ratio of 1 will generally not give us many options today.
We can account for this change in the nature of the business.
Value investing is not a static paradigm. The practice changes and evolves.
That brings me to the Return on Equity metric.
Warren Buffett’s Favorite Metric
The argument goes like this – a company that can generate a better return on its equity than competitors and can reliably keep it up over time, does so because it possesses some kind of competitive advantage.
Or otherwise called a MOAT.
When you find a company that has a defensible moat, you can get away buying it at a fair or even slightly overvalued price. Over time, the competitive advantage will work in your favor and you will get a good return.
As you would note, Warren Buffett abandoned classic value investing long time ago and starting buying good companies at fair price.
For one, he became too large to be able to invest as a classical value investor. These tend to be smaller companies, too small for Buffett to buy. And of course, Munger had a big hand in changing his style towards the “Quality” investments.
Nothing wrong with this. This is a proven strategy that works in the right hands.
The point I am making is that when Buffett talks about increasing irrelevance of Book Value, he does not mean it is no longer relevant for value investors.
It is just no longer relevant for what he does.
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