The Art of Business Valuation

Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined. Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value. Projected results are less precise still. You cannot appraise the value of your home to the nearest thousand dollars. Why would it be any easier to place a value on vast and complex businesses?

Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors. So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal.

Any attempt to value businesses with precision will yield values that are precisely inaccurate. The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones. Anyone with a simple, hand-held calculator can perform net present value (NPV) and internal rate of return (IRR) calculations. The NPV calculation provides a single-point value of an investment by discounting estimates of future cash flow back to the present. IRR, using assumptions of future cash flow and price paid, is a calculation of the rate of return on an investment to as many decimal places as desired. The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really only as accurate as the cash flow assumptions that were used to derive them.

The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts. Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions. “Garbage in, garbage out” is an apt description of the process.

NPV and IRR are wonderful at summarizing, in absolute and percentage terms, respectively, the returns for a given series of cash flows. When cash flows are contractually determined, as in the case of a bond, and when all payments are received when due, IRR provides the precise rate of return to the investor while NPV describes the value of the investment at a given discount rate. In the case of a bond, these calculations allow investors to quantify their returns under one set of assumptions, that is, that contractual payments are received when due. These tools, however, are of no use in determining the likelihood that investors will actually receive all contractual payments and, in fact, achieve the projected returns.

Businesses, unlike debt instruments, do not have contractual cash flows. As a result, they cannot be as precisely valued as bonds. Benjamin Graham knew how hard it is to pinpoint the value of businesses and thus of equity securities that represent fractional ownership of those businesses. In Security Analysis he and David Dodd discussed the concept of a range of value:

“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.”

Indeed, Graham frequently performed a calculation known as net working capital per share, a back-of the envelope estimate of a company’s liquidation value. His use of this rough approximation was a tacit admission that he was often unable to ascertain a company’s value more precisely.

Markets exist because of differences of opinion among investors. If securities could be valued precisely, there would be many fewer differences of opinion; market prices would fluctuate less frequently, and trading activity would diminish. To fundamentally oriented investors, the value of a security to the buyer must be greater than the price paid, and the value to the seller must be less, or no transaction would take place. This discrepancy between the buyer’s and the seller’s perceptions of value can result from such factors as differences in assumptions regarding the future, different intended uses for the asset, and differences in the discount rates applied. Every asset being bought and sold thus has a possible range of values bounded by the value to the buyer and the value to the seller; the actual transaction price will be somewhere in between.

To be a value investor, you must buy at a discount from underlying value. Analyzing each potential value investment opportunity therefore begins with an assessment of business value. While a great many methods of business valuation exist, there are only three that Seth Klarman finds useful. The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor’s assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety.

The second method of business valuation analyzes liquidation value, the expected proceeds fo a company were to be dismantled and the assets sold off. Breakup value, one variant of liquidation analysis, considers each of the components of a business as its highest valuation, whether as part of a going concern or not.

The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Each of these methods of valuation has strengths and weaknesses. None of them provides accurate values all the time. Unfortunately, no better methods of valuation exist. Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism.

Present-Value Analysis

When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately, future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present-value analysis an imprecise and difficult task.

A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate very year. Real businesses, even the best ones, are unfortunately not annuities. Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. Small changes in either revenues or expenses cause far greater percentage changes in profits. The number of things that can go wrong greatly exceeds the number that can go right. Responding to business uncertainty is the job of corporate management. However, controlling or preventing uncertainty is generally beyond management’s ability and should not be expected by investors.

Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. The future is not predictable, except within fairly wide boundaries. Will Coca-Cola sell soda next year? Of course. Will it sell more than this year? Pretty definitely, since it has done so every year since 1980. How much more is not so clear. How much the company will earn from selling it is even less clear; factors such as pricing, the sensitivity of demand to changes in price, competitors’ actions, and changes in corporate tax rates all may affect profitability. Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast.

There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business’s present value. Yet several difficulties confront growth-oriented investors. First, such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted. Second, for fast-growing businesses even small differences in one’s estimate of annual growth rates can have a tremendous impact on valuation. Moreover, with so many investors attempting to buy stocks in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals. Since entry to the “Business Hall of Fame” is frequently through a revolving door, investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses. When growth is anticipated and therefore already discounted in securities prices, shortfalls will disappoint investors and result in share price declines. As Warren Buffett has. Said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

Another difficulty with investing based on growth is that while investors tend to oversimplify growth into. Single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. For any particular business, for example, earnings growth can stem from increased unit sales related to predictable increases in the general population, to increased usage of a product by consumers, to increased market share, to greater penetration of a product into the population, or to price increases. Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of nonalcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits.

Some of these sources of earnings growth are more predictable than others. Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer. The reaction of customers to price increases is always uncertain. On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits.

An unresolvable contradiction exists: to perform present-value analysis, you must predict the future, yet the future is not reliably predictable. How do value investors deal with the analytical necessity to predict the unpredictable? The only answer is conservatism. Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors. A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments. Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today’s.

There is no single correct discount rate for a set of future cash flows and no precise way to choose one. The appropriate discount rate for a particular investment depends not only on an investor’s preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.

Investors tend to oversimplify; the way they choose a discount rate is a good example of this. A great many investors routinely use 10% as an all-purpose discount rate regardless of the nature of the investment under consideration. Ten percent is a nice round number, easy to remember and apply, but it is not always a good choice.

The underlying risk of an investment’s future cash flows must be considered in choosing the appropriate discount rate for that investment. A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which are considered a proxy for the risk-free interest rate. Low-grade bonds, by contrast are discounted by the market at rates of 12 to 15 percent or more, reflecting investors’ uncertainty that the contractual cash flows will be paid.

It is essential that investors choose discount rates as conservatively as they forecast future cash flows. Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation.

Business value is influenced by changes in discount rates and therefore by fluctuations in interest rates. While it would be easier to determine the value of investments if interest rates and thus discount rates were constant, investors must accept the fact that they do fluctuate and take what action they can to minimize the effect of interest rate fluctuations on their portfolios.

How can investors know the “correct” level of interest rates in choosing a discount rate? There is no “correct” level of rates. They are what the market says they are, and no one can predict where they are headed. It’s probably fair to give current, risk-free interest rates the benefit of the doubt and assume that they are correct. Like many other financial-market phenomena there is some cyclicality to interest rate fluctuations. High interest rates lead to changes in the economy that are precursors to lower interest rates and vice versa. Knowing this does not help one make particularly accurate forecasts, however, for it is almost impossible to envision the economic cycle until after the fact.

At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive.

Investors can apply present-value analysis in one of two ways. They can calculate the present value of a business and use it to place a value on its securities. Alternatively, they can calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimated future share prices in the case of stockholders.

Calculating the present value of contractual interest and principal payments is the best way to value a bond. Analysis of the underlying business can then help to establish the probability that those cash flows will be received. By contrast, analyzing the cash flows of the underlying business is the best way to value a stock. The only cash flows that investors typically receive from a stock are dividends. The dividend-discount method of valuation, which calculates the present value of a projected stream of future dividend payments, is not a useful tool for valuing equities; for most stocks, dividends constitute only a small fraction of total corporate cash flow and must be projected at least several decades into the future to give a meaningful approximation of business value. Accurately predicting that far ahead is an impossibility.

Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers. In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value. If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation.

Private-Market Value

A valuation method related to net present value is private-market value, which values businesses based on the valuation multiples that sophisticated, prudent businesspeople have recently paid to purchase similar businesses. Private-market value can provide investors with useful rules of thumb based on the economics of past transactions to guide them in business valuation. This valuation method is not without its shortcomings, however. Within a given business or industry all companies are not the same, but private-market value fails to distinguish among them. Moreover, the multiples paid to acquire businesses vary over time; valuations may have changed since the most recent similar transaction. Finally, buyers of businesses do not necessarily pay reasonable, intelligent prices.

The validity of private-market value depends on the assumption that businesspeople know what they are doing. In other words, when businesspeople consistently pay a certain multiple of revenues, earnings, or cash flow for a business, it is assumed that they are doing so after having performed an insightful analysis of the underlying economics. Often they have. After all, if the prices paid were routinely too high, the eventual losses incurred would inform subsequent buyers who would pay less in the future. If the prices paid were too low, the buyers would earn high returns; seeing this, others would eventually bid prices up to levels where excess profits could no longer be achieved. Nevertheless, the fact is that the prices paid by buyers of businesses can diverge from the underlying economics of those businesses for long stretches of time.

Investors must ignore private-market values based upon inflated securities prices. Investors relying on conservative historical standards of valuation in determining private-market value will benefit from a true margin of safety, while others’ margin of safety blows with the financial winds.

How do sophisticated private-market buyers themselves evaluate businesses for possible purchase? In general, they make projections of free cash flow and then calculate the present value of those cash flows, evaluating the impact of differing assumptions on valuation. In other words, they perform present-value analysis.

What distinguishes private-market-value analysis from present-value analysis is the involvement of the middleman, the sophisticated businessperson, whose role has both positive and negative aspects. On the positive side, if the middleman makes a sizable financial commitment, this may help to corroborate the investors’ own present-value analysis. On the negative side, relying on the judgment of a buyer of businesses, who may or may not be truly knowledgeable and insightful, can cause investors to become complacent and to neglect to perform their own independent valuations as a check. Seth Klarman’s personal rule is that investors should value businesses based on what they themselves, not others, would pay to own them. At most, private-market value should be used as one of several inputs in the valuation process and not as the exclusive final arbiter of value.

Liquidation Value

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment.

A liquidation analysis is a theoretical exercise in valuation but not usually an actual approach to value realization. The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value is generally a worst-case assessment. Even when an ongoing business is dismantled, many of its component parts are not actually liquidated but instead are sold intact as operating entities. Breakup value is one form of liquidation analysis; this involves determining the highest value of each component of a business, either as an ongoing enterprise or in liquidation. Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value.

How should investors value assets in a liquidation analysis? An orderly liquidation over time is virtually certain to realize greater proceeds than a “fire sale,” but time is not always available to a company in liquidation. When a business is in financial distress, a quick liquidation (a fire sale) may maximize the estate value. In a fire sale the value of inventory, depending on its nature, must be discounted steeply below carrying value. Receivables should probably be significantly discounted as well; the nature of the business, the identity of the customer, the amount owed, and whether or not the business is in any way ongoing all influence the ultimate realization from each receivable.

When no crisis is at hand, liquidation proceeds are usually maximized through a more orderly winding up of a business. In an orderly liquidation the values realized from disposing of current assets will more closely approximate stated book value. Cash, as in any liquidation analysis, is worth one hundred cents on the dollar. Investment securities should be valued at market prices, less estimated transaction costs in selling them. Accounts receivable are appraised at close to their face amount. The realizable value of inventories—tens of thousands of programmed computer diskettes, hundreds of thousands of purple sneakers, or millions of sticks of chewing gum—is not so easily determinable and may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence. The value of the inventory in a supermarket does not fluctuate much, but the value of a warehouse full of computers certainly may. Obviously, a liquidation sale would yield less for inventory than would an orderly sale to regular customers.

The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flows, either in the current use or in alternative uses. Some machines and facilities are multipurposed and widely owned; others may have value only to the present owner. The value of restaurant equipment, for example, is more readily determinable than the value of an aging steel mill.

In approximating the liquidation value of a company, some value investors, emulating Benjamin Graham, calculate “net-net working capital” as a shortcut. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year). Net-net working capital is defined as net working capital minus all long-term liabilities. Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all its liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company’s current operations before buying. Investors should also consider any off-balance sheet or contingent liabilities, such as underfunded pension plans, as well as any liabilities that might be incurred in the course of an actual liquidation, such as plant closing and environmental laws.

A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation or breakup of a company is a catalyst for the realization of underlying business value. Since value investors ttempt to buy securities trading at a considerable discount from the value of a business’s underlying assets, a liquidation is one way for investors to realize profits.

A liquidation is, in a sense, one of the few interfaces where the essence of the stock market is revealed. Are stocks pieces of paper to be endlessly traded back and forth, or are they proportional interests in underlying businesses? A liquidation settles this debate, distributing to owners of pieces of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation thereby acts as a tether to reality for the stock market, forcing either undervalued or overvalued share prices to move into line with actual underlying value.

Stock Market Value

Occasionally investors must rely on the public equity and debt markets to provide an approximation of the worth of a security. Sometimes, as in the case of a closed-end mutual fund, this is the only relevant valuation method. Other times, especially if the time frame in which the value must be realized is short, the stock market method may be the best of several poor alternatives.

Stock market value applies in other situations as well. In attempting to value a company’s interest in an unrelated subsidiary or joint venture, for example, investors would certainly consider the discounted anticipated future cash flow stream (net present value), the valuation of comparable businesses in transactions (private-market value), and the value of tangible assets net of liabilities (liquidation value). Investors would also benefit from considering stock market value, the valuation of comparable businesses is but one of several valuation tools and provides a yardstick of what a security, if not a business, might bring if sold tomorrow.

Stock market value has its shortcomings as a valuation tool. You would not use stock market value to appraise each of the companies in an industry. It would be circular reasoning to bserve that since newspaper companies tend to trade in the market at, say, eight times pretax cash flow, that is what they must be worth. Knowing the stock market’s appraisal for the newspaper industry would be of some use, however, in estimating the near-term trading price of the newspaper subsidiary about to be spun off to the shareholders of a media conglomerate.

Choosing Among Valuation Methods

How should investors choose among these several valuation methods? When is one clearly preferable to others? When one method yields very different values from the others, which should be trusted?

At times a particular method may stand out as the most appropriate. Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low. Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis. Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value. A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense.

Often several valuation methods should be employed simultaneously. To value a complex entity such as a conglomerate operating several distinct businesses, for example, some portin of the assets might be best valued using one method and the rest with another. Frequently investors will want to use several methods to value a single business in order to obtain a range of values. In this case investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reason to do otherwise. True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

The Reflexive Relationship Between Market Price and Underlying Value

A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses. In The Alchemy of Finance George Soros stated, “Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.” In other words, Soros’s theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business. Investors must not lose sight of this possibility.

Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy. The stock market says there is no problem, so there is no problem.

The same holds true for a highly leveraged company with an upcoming debt maturity. If the market deems the company creditworthy, the company will be able to refinance and fulfill the prophecy. If the market votes thumbs down on the credit, however, that prophecy will also be fulfilled since the company will then fail to meet its obligations.

Another form of reflexivity exists when the managers of a business accept its securities’ prices, rather than business fundamentals, as the determining factor in valuation. If the management of a company with an undervalued stock believes that the depressed market price is an accurate reflection of value, they may take actions that prove the market right. Stock could be issued in a secondary offering or merger, for example, at a price so low that it significantly dilutes the value of existing shares.

As another example of reflexivity, the success of a reorganization plan for a bankrupt company may depend on certain values being realized by creditors. If the financial markets are depressed at the time of reorganization, it could be difficult, perhaps impossible, to generate agreed values for creditors if those values depend on the estimated market prices of debt and equity securities in the reorganized company. In circular fashion, this could serve to depress even further the prices of securities in this bankrupt company.

Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by the financial markets themselves.

Conventional Valuation Yardsticks

Earnings and Earnings Growth

So far, there has been virtually no mention of earnings, book value, or dividend yield. Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Earnings per share has historically been the valuation yardstick most commonly used by investors. Unfortunately, it is an imprecise measure, subject to manipulation and accounting vagaries. It does not attempt to measure the cash generated or used by a business. And as with any prediction of the future, earnings are nearly impossible to forecast.

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend. A few particularly unscrupulous managements play accounting games to turn deteriorating results into improving ones, losses into profits, and small profits into large ones.

Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business. Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality. By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business. By contracts, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors.

Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.

Book Value

What something costs in the past is not necessarily a good measure of its value today. Book value is the historical accounting of shareholders’ equity, the residual after liabilities are subtracted from assets. Sometimes historical book value (carrying value) provides an accurate measure of current value, but often it is way off the mark. Current assets, such as receivables and inventories, for example, are usually worth close to carrying value, although certain types of inventory are subject to rapid obsolescence. Plant and equipment, however, may be outmoded or obsolete and therefore worth considerably less than carrying value. Alternatively, a company with fully depreciated plant and equipment or a history of write-offs may have carrying value considerably below real economic value.

Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. Real estate purchased decades ago, for example, and carried on a company’s books at historical cost may be worth considerably more. The cost of building a new oil refinery today may be made prohibitively expensive by environmental legislation, endowing older facilities with a scarcity value. Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built minimills. As a result, their book value may be significantly overstated.

Reported book value can also be affected by management actions. Write-offs of money-losing operations are somewhat arbitrary yet can have a large impact on reported book value. Share issuance and repurchases can also affect book value. Many companies in the 1980s, for example, performed recapitalizations, whereby money was borrowed and distributed to shareholders as an extraordinary dividend. This served to greatly reduce the book value of these companies, sometimes below zero. Even the choice of accounting method for mergers—purchasing or pooling of interests—can affect reported book value.

To be useful, an analytical tool must be consistent in its valuations. Yet, as a result of accounting rules and discretionary management actions, two companies with identical tangible assets and liabilities could have very different reported book values. This renders book value not terribly useful as a valuation yardstick. As with earnings, book value provides limited information to investors and should only be considered as one component of a more thorough and complete analysis.

Dividend Yield

Although at one time a measure of a business’s prosperity, dividend yield has become a relic: stocks should simply not be bought on the basis of their dividend yield. Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more. Investors buying such stocks for their ostensibly high yields may not be receiving good value. On the contrary, they may be the victims of a pathetic manipulation. The high dividend paid by such companies is not a return on invested capital but rather a return of capital that represents the liquidation of the underlying business.


Business valuation is a complex process yielding imprecise and uncertain results. Many businesses are so diverse or difficult to understand that they simply cannot be valued. Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipline required by value investing. Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor’s results. For every business that cannot be valued, there are many others that can. Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.