A Tale of Two Figures
Two weeks ago I wrote a post discussing book value and how investors could use the metric. The great discussion that ensued, both in the comments and in the realms of my fellow bloggers, highlighted quite nicely how even the basic building blocks of investment analysis can be interpreted in so many different ways. That’s the reason that it’s far from uncommon to read a shockingly bearish report, and agree entirely – but then to wander across to the territory of those who hold the stock, and find equally plausible reasons for the share price to double. Usually immediately. Shareholders are usually filled with the conviction that it should go up fast!
There is one point in that post, though, that I’d like to talk about a little further:
On the other hand, some of the companies my portfolio owns don’t have particularly impressive book values – that is to say, I paid more for the company than I actually received in tangible assets. In this case, then, it may appear that I’m throwing money down the drain. What gives? Well, here I’ll attempt to highlight two main ways I think about book values and how they help my analysis of a company.
This is clearly true. Not all the companies in my portfolio are trading at discounts to tangible book value – in fact, far from it. There’s one company – Creston- that stands out in particular, though, as not only does it not trade at a discount to tangible book value, it trades at a negative tangible book value. The difference between these lies in the deduction of liabilities. A company with £100m of property and £50m of debt will have a positive book value – but the magnitude of that price to book value , from 0 to infinity, is decided by the market. But the market, no matter how highly it prices the company, cannot make a company trade at a negative PTBV – that requires total liabilities exceeding total tangible assets. Given my previous stance, then, it may sound like these companies are my worst nightmare; where is the ‘margin of safety’ I cherish? As always, there’s more than one way of looking at it!
The market has been generous enough to provide me with a nice big pool of examples recently, and probably the best ones I can think of off the top of my head are media and communications companies. The list above was generated using SharelockHolmes and searching for small cap firms with low forward P/Es, and we notice a rather obvious trend – a swathe of companies look very cheap on an earnings basis (assuming the brokers are right), moderate on a book value basis, and very steeply negative on a tangible book basis. To me, then, they make great stocks to analyse and good illustrators of the point I’m trying to make.
How tangible is tangible?
That may seem like a funny question, but it’s far from it. When considering companies tangible current assets, we’re always quick to look at the make up of those assets. Are they mainly inventories? Properties which are undervalued on book? The king of all – cash? Receivables of doubtful value? All perfectly relevant questions; indeed, I remember Richard Beddard actually using a model (for liquidation analysis) which assigned a weight to each of these classes in reference to how much it could actually be sold for. While we go to all those pains to consider tangible assets, then, why are we so quick to lump all intangibles together?
Deferred tax is an intangible asset – it has no saleable monetary worth. In reality, though, if the company will be making a profit in the next few years the asset has a clear and logical conversion into cashflow. The asset will disappear and while technically the cash isn’t ‘added’, it’s not taken away, which is just as good! What about brand recognition? Can it be sold? Perhaps it can – if the name’s good enough. Even if it can’t, consider where the value added is in a business – using Coca-Cola as an example, the brand is an intangible while the machines that produce the stuff are tangible. Which one is really adding the value?
Of course, very few companies have a brand with such incredible worldwide recognition, but there is certainly something to be said for being well respected with the niche you operate in, so it seems likely that a good solid business name will always be worth something.
One particularly important thing to think about when diving into the intangibles, though, is what they’re actually tried to measure. That may sound obvious, but it’s worth repeating – while I’m not an accountant and not versed in the formal rules, my jolly around the investment universe certainly points to the conclusion that there is a great deal of discretion in what you actually measure as an intangible asset. One key point for some of the media companies is that they are very aggressive in the things they seem to value. I even bolded it for aggressive emphasis! As an example, if I flick to Huntsworth’s annual report, I see a rather staggering £291m of intangible assets. £250m of this is goodwill. What does this comprise of? Well, they and Creston essentially do investors’ jobs for them here – they have done a discounted cash flow analysis on every one of their ‘cash generating units’, in Huntsworth’s case with a discount rate of 12.8%. Operating cash flow forecasts were provided by the directors.
This is far from normal – most of the companies I look at don’t value their future cashflows on their book as a current asset – primarily, I expect, because they don’t need to. It appears intangibles pop up to prevent firms from reporting that rather ominous sounding phrase – negative equity. In some ways it’s interesting, though, as while we don’t know the forecasts we can jig around the figures and try to see what’s going on – a high discount rate is a positive, for instance, and it’d be nice to see some conservative long-term growth rate assumptions.
Either way, the key point is to know what’s being valued and what isn’t.
My final thought is an important note of caution. I’ve already said you can account for lots, nothing, and essentially justify any valuation. What’s key is being honest and logical, though, and looking at all of the companies you analyse on an equal base. That’s why, for instance, I stripped out Creston’s DCF-based goodwill balance when I decided to include them in the portfolio. I don’t include DCFs of future revenue in the ‘assets’ of Barratt, Howden Joinery or N Brown, for instance, so why should I do so for Creston? If I believe their forecasts, there’s no point in me anlysing them anyway – they’re trading at about half the value of that analysis, so I should be filling my boots!
The interaction between these intangibles and the income statement is complicated, but also bears remembering. A firm with a higher ‘brand value’ will be able to enjoy higher margins than one which does not – or should that be firms with higher margins demonstrably have bigger brand values? That’s something else to think about, but either way, be consistent with how you are considering brand value across businesses.
I bought Creston because I felt the value of their future earnings – essentially a DCF – significantly outweighed the fact that they’re currently rather light on the assets. Other firms I buy for exactly the opposite reason. Maybe I am as good as a monkey throwing darts at a board – or worse – but knowledge is power, as I think there’s value in knowing how you yourself think about things. Investing is a game of information – if you can collect, analyse and apply principles better than the market you’ll win. Knowing your own thought pattern will always help that process.