Robert wrote an article a few weeks ago about whether or not book value mattered when making an investment. He wrote about mREITs, and whether or not a book value was a good indicator of a company’s actual value.
Since mortgage REITs are really just a portfolio of leveraged debt investments, book value is everything. In some cases, book value can steer you wrong.
BlackBerry’s Black Box
BlackBerry (BBRY) is in the midst of a bitter battle for phone supremacy. It’s also at the center of discussion among value investors, who wish to discover what the company is actually worth.
If you look at the financial statements, BlackBerry is rich! The company reports $7.1 billion in current assets (cash, inventories, and receivables) against total liabilities of just half that, or $3.4 billion. Subtract total debt from current assets and you find that the company is worth a minimum of $3.7 billion if you were to liquidate it today.
If you include all reported assets, the company has equity of $9.4 billion. Its market cap, however, is only $5 billion. Thus, the reported value of its assets minus all debts is well above the cost to buy the company outright. So, if the numbers are accurate, BlackBerry is currently selling for almost half of the asset value. Why would such a disparity exist?
Why Book Value Can Mislead Investors
For purely financial companies like banks or mREITs, there is no better metric than book value. As companies diverge from financing, however, book value can send investors into a value trap.
BlackBerry trades under book value for any number of reasons:
No Liquidation in Sight
Even if reported book value of $9.4 billion were correct, there is no way to know if that money will ever flow to shareholders. Suppose BlackBerry were to continue operating at a loss for the next five years and lose $1 billion per year along the way. The net asset value falls to $4.1 billion, which is less than the current $5 billion market cap.
If it were to liquidate after that five-year period, investors would lose money, even if the company were tremendously undervalued in year one. Remember, we’re small shareholders who have virtually no influence over a multinational company.
Reported Asset Values May Be Incorrect
Let’s be clear: BlackBerry’s reported cash, investments, inventories, and receivables are undoubtedly accurate. That’s simple tabulation. However, other assets carry a value that has more to do with qualitative value than a quantitative value. BlackBerry reports having $3.5 billion of intangible assets — patents, trademarks, logos, and brand goodwill.
These assets have subjective value. BlackBerry may have paid $100 million to secure a patent, for example, but that doesn’t mean the patent has a current market value of $100 million. It might be worth only $20 million or perhaps nothing at all, in which case this asset has an overstated value on the balance sheet.
Asset Values Are Tied to Profitability
Suppose you spend $500,000 to purchase assets to start a new business. If this new business consistently earns $100,000 per year, then the assets are certainly worth $500,000. Anyone who buys the business from you would earn a 20 percent return.
If, however, your business only earns $10,000 per year after a $500,000 investment, it would be very, very hard to sell that business to someone else for $500,000. No one in their right mind would pay $500,000 for a risky business to earn a 2 percent return when they could invest in risk-free U.S. Treasuries and earn more with zero risk.
In short, buyers don’t care how much you paid for something. They care how big their returns will be on your somethings. BlackBerry reports having more than $13 billion in assets working for the business, but earnings are negative. Would you pay $13 billion for the right to lose money each year? No rational person would.
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Book Value Requires Investigation
Book values can be terribly inaccurate. Some sources of inaccuracy include real estate, which is held at cost despite the fact that real estate values can fluctuate wildly from the time of purchase. Intangible assets like goodwill and trademarks may have some value, but they aren’t worth much unless the assets can be sold at their accounting value.
Over history, the cheapest stocks by price to book value have outperformed the market. However, the lowest P/B stocks had the smallest outperformance relative to stocks selected by other common financial ratios.
It’s likely that the lowest P/B financial stocks would have absolutely decimated every other category. However, non-financial companies cannot be understood by simple book value ratios. You have to find the assets that back the book value, and do some due diligence to see whether or not those assets are worth what the accounting says they are. In many cases, reported book value for non-financial companies vastly overstate or understate the true value of the company in liquidation.
What are your thoughts on book value and the huge gap in Blackberry’s black box?