Basing my company valuations on book value is nice and everything, and has a lot of historical and empirical support, but I’ve always had a nagging doubt about my core assumption in relation to earnings:

“Any reasonably competent management should be able to produce returns at some point such that the company is worth its net asset value.”

This is the basis on which I expect to exit the companies I own.  Most companies that are priced well below book value do eventually end up back above it and usually via a higher share price rather than a lower book value.

Reading through some of the obligatory writings of a certain Mr Buffett however, highlights a consequence of ignoring earnings:

“When Buffett Partnership, Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway, it had an accounting net worth of $22 million, all devoted to the textile business.  The company’s intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value.  Indeed, during the previous nine years (the period in which Berkshire and Hathaway operated as a merged company) aggregate sales of $530 million had produced an aggregate loss of $10 million.  Profits had been reported from time to time but the net effect was always one step forward, two steps back.”

The risk to an investor like me is that a company will never sell at book value because it is just not worth that much even with the best management.  Looking at my own holdings, Northamber (LON:NAR) had produced average returns on equity of 3.8% over the past decade, 600 Group (LON:SIXH) had managed 2% and MJ Gleeson 2.3% (according to Sharelockholmes).  Not exactly electrifying and not a return you’d want to leave the safety of a savings account for.

But does this matter?  Well, perhaps.  Looking back at my ex-holdings and plotting the annualised returns I got from buying and selling them against their 10 year ROE I get the following:

ROE chart

Unfortunately that’s not a lot of data,  but it’s a start for sure and does seem to imply what I’d intuitively expect – that those companies with…

Unlock the rest of this article with a 14 day trial

Already have an account?
Login here