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Warren Buffett: Book Value Does Not Intrigue Us

- By Rupert Hargreaves

Book value is generally considered to be the go-to metric for value investors who want to assess a company's potential.

The idea of valuing a company compared to its book value, or shareholder equity, was first popularized by the father of value investing, Benjamin Graham.

Graham believed that if you could buy a company for less than it was worth, your risk of a total capital impairment was significantly reduced. To simplify this equation further, he advised using book value per share as one component of a calculation to try and estimate a company's intrinsic value.


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Net-nets

When he started his own investment partnerships in the mid-1950s, Warren Buffett (Trades, Portfolio) adopted a similar approach. He set out to look for so-called net-net stocks, which were securities trading below the value of their net current assets.

This strategy initially proved to be extremely lucrative, but in the mid-1960s, the world started to change and the dissemination of financial information improved. The number of deep-value stocks began to shrink, so Buffett decided to close his partnerships. Over the next several decades, the Oracle of Omaha's investment strategy transitioned away from using book value as one of the primary factors of calculating intrinsic value toward cash flows and growth potential.

We can argue this process finally concluded at the beginning of this year when Buffett abandoned book value as his preferred metric of wealth creation at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). In his 2018 letter to shareholders, he wrote:


"Longtime readers of our annual reports will have spotted the different way in which I opened this letter. For almost three decades, the initial paragraph featured the percentage change in Berkshire's per-share book value. It's now time to abandon that practice."



The downside of book value

As noted above, Buffett hasn't used book value to evaluate businesses for decades. If we go back to the 1998 Berkshire annual meeting, we are offered some explanation as to why this is the case.

During the question-and-answer session of the meeting, one shareholder asked Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), what they thought about Japanese stocks, particularly those trading at a discount to book value, as they seemed to offer much more value than the U.S. counterparts.

Buffett said Japanese stocks were bound to sell at a lower price-book ratio than U.S. stocks because "Japanese companies are earning far less on book than American companies." He went on to add:


"And earnings are what determine value, not book value. Book value is not a factor we consider. Future earnings are a factor we consider. And as we mentioned earlier this morning, earnings have been poor for a great many Japanese companies."



The only time it would make sense to buy companies earning a low return just because they look cheap is "if you think the return on equity of Japanese businesses is going to increase dramatically." He went on to explain that if you believe this to be the case, and you end up being correct, you could make a lot of money.

For the most part, however, the return on equity for Japanese businesses has been quite low. Therefore, the low book value is appropriate. He said, "If a company's earning 5% on book value, I don't want to buy it at book value if I think it's going to keep earning 5% on book value. So a low price-book ratio means nothing to us. It does not intrigue us."

The Oracle of Omaha summarized this topic by saying he is much more likely to be attracted to a company that is trading at a high ratio of book value rather than a low one because "the chances are we are looking at a poor business in the first case and a good business in the second case."

Yet another interesting insight into the way Buffett thinks and goes about evaluating businesses.

Disclosure: The author owns shares of Berkshire Hathaway.

Read more here:

  • Berkshire Hathaway: It's All About Downside Protection
  • Could This Be Buffett's Next Big Acquisition?
  • Charlie Munger on Where Benjamin Graham Went Wrong



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This article first appeared on GuruFocus.