Saturday, June 16, 2007

Book Value, Intrinsic Value and Business Valuation

Let’s distinguish the difference between Book Value and Intrinsic Value. Book Value is the amount that has been pumped into a venture because whatever amount that has been invested is being recorded on the book – even if it at an overpaid price. What has been invested in a business does not guarantee what can be generated out of the business. But to make a profitable deal, what counts is what can be generated out from what has been fed into it. In this case, Intrinsic Value is the measurement of what can eventually be taken out from the business. Simply put, Book Value as a measurement or proxy for the relative attractiveness of a business or its intrinsic value is meaningless.

In reality, the value between the two is often different, sometimes vastly so. In the event than intrinsic value exceeds the book value, whoever that invested in the business got his money worth. Since intrinsic value is a calculation based on the sum of all the business cash flows during its remaining life, it pays for investors to act only on businesses which are certain to produce a steady and predictable cash flow, and at the same time, the business must not be easily vulnerable to new or current competition.

You can gain an insight into the difference between Book Value and Intrinsic Value by comparing the current earning power of an undergraduate and a blue-collar worker. The undergraduate may be earning $1000 monthly on a part-time job while the blue-collar worker is earning $2000 monthly. If the earning is treated as the Book Value, then is it a true indication of the intrinsic value of them? Obviously, the intrinsic value of the undergraduate is much higher than what his book value today suggests when he graduates.

Now, let’s do an example based on a fictitious business offer as if it is available to you as a whole. Assuming there’re two businesses making chewing gum, Wrigleys and China Gum, up for sale. Each possesses vastly different business economics and competitive advantages. Wrigleys is available at a price tag of $50 million and China Gum is available for $36 million. Each of them earns $4 million. In other words, the PE ratio is 12.5 for Wrigleys and 9 for China Gum, which will you chose? I bet most of you’d chose China Gum since it costs $14 million lesser while earning the same profit, and also, it takes a shorter time to recoup the capital invested.

Now, let’s throw in some more important information. Wrigleys’ net tangible asset is $16 million and China Gum is $36 million. This works out at a return of 25% on net tangible assets for Wrigleys and 11% for China Gum. Now, we do know a little bit more why did Wrigleys commands a premium of $34 million over its tangible assets. China Gum while making the same profit may well thus be sold for the value of its net tangible assets because the business possesses little or no economic goodwill. But then, if you pay $50 million for Wrigleys, then effectively, an investor return on the business is 8%, of which $34 million will be recorded in the balance sheet as Goodwill, and $16 million as tangible assets.

So, in this case, is it still worthwhile to buy Wrigleys over China Gum? The answer is a resounding “Yes” even if both businesses are expected to have flat unit volume as long as you anticipate a world of continuous inflation. To understand why, we must understand the workings of inflation and that it is inevitable over time.

What happens in an inflationary world? It simply means prices in the future will be higher than today for the same service or product rendered. In the long run, inflation is nothing but a certainty and it is inevitable. Imagine the impact that a doubling of price level will have on both businesses. Both would need to double their earnings to $8 million to keep themselves even with inflation. This would seem easy: just sell the same number of units at double the earlier price and assuming profit margins remain unchanged, profit must then double.

But more importantly, to bring that about, both businesses would have to double their nominal investment in net tangible assets, given that that is the kind of economic requirement that inflation usually imposes on businesses, good or bad. And all this inflation-required investments will produce no improvement in the rate of return. The reason for this investment is the survival of the business, not the prosperity of the owner.

Remember that Wrigleys had net tangible assets of $16 million. Thus, because of the inflation, they had to commit an additional $16 million to fund the capital needs. China Gum, however, had a burden over twice as large by investing an additional of $36 million in capital.

After the dust had settled, China Gum now earning $8 million annually might well be worth the value of its tangible assets, or $72 million. This means its owners would have only garnered a dollar worth of nominal value for every new dollar invested.

However, Wrigleys, also earning $8 million might well be worth $100 million (as it logically would be) on the same basis as it was originally available. So it would have gained $50 million in nominal value while its owners just put up $16 million in additional capital – over $3 of nominal value gained for every dollar invested.

Because of inflation, both businesses were forced to put up additional capital just to stay even with inflation for real profits. However, in this case, China Gum although doubling their earnings did not get any real growth in earnings because it is eaten up by inflation – they were having the same purchasing power when they earn $8 million as when they were earning $4 million. But it is different for Wrigleys, the owners got more than a dollar worth of value for each dollar invested in times of inflation. Simply, Wrigleys was beating the rate of inflation.

Any business that requires some form of tangible assets to operate (and almost all do) is hurt by inflation. Thus, businesses needing the least or little in the way of tangible assets simply are hurt the least.

The reality of this has been difficult for many people to appreciate. For years, tradition wisdom held that assets are the best protection for inflation. Thus, businesses laden with natural resources, plant and equipments, or any other tangible assets, are thought to be the best protection against inflation. But unfortunately, it doesn’t work that way. Sad to say some traditions are “long on tradition, short on wisdom.” Inflation is best protected by the earning power of the asset, not the book value. Asset-heavy businesses tend to earn low rate of return – to the point that barely provide enough capital to fund the inflationary needs of the business, with nothing left for real growth, for distribution to owners, or for acquisition of new businesses.

During the inflationary years, a disproportionate number of great businesses fortunes were built up by operations that combined intangibles or goodwill with lasting economic value with relatively small requirements for tangible assets. In such cases, earnings have spiraled upwards in nominal dollars with little in the way of additional capital, and these nominal dollars have largely been used to acquire new businesses or repurchase outstanding shares. In times of inflation, Goodwill is the gift that keeps giving.

But that statement is only valid to true economic goodwill. Spurious accounting goodwill is another matter and there’re plenty around. When a management purchases a business at a silly price, the same accounting treatment is observed. Because Goodwill cannot go anywhere else, the silliness ends up in the Goodwill account. Due to the lack of managerial discipline and business-savvy, the account was created and it is treated as an asset as if the acquisition had been a sensible one. But for any past silliness, the future pays for it. When someone try to reach for the silliness, the Goodwill just melts away and then to bring the acquisition closer to what is intrinsically worth, an impairment of Goodwill will have to be taken to make up for the past accounting shenanigans.

In taking silliness of such business deal to the forefront, imagine you are an undergraduate, would you merge your earnings, although you’re not earning a single cent today, with a plumber who earns $2000 monthly on a 50/50 basis so as to get $1000 monthly? If you merge, after you graduate, and if you command $3000 monthly, you’d then have to combine your pay with the plumber’s pay, and you’d get only $2500 because of the decision you took to merge. You think this is ridiculous, isn’t it? But that’s what has been happening in the business world where management simply is that silly – well, I can’t say they are that silly, maybe they’ve got their personal agenda to enrich themselves rather than to look after the shareholder’s value.

And the plumber said with a parting shot to the undergraduate when they merged: “Promise never to do a deal this dumb in the future.”

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