When Book Value is Rubbish

Firstly, for some academic background to this article read this one: Smoke, Mirrors & Balance Sheets.

Now, when is it justified that a stock trades below book value?

Well, the answer is simple enough: when book value is overstated.

But how do we get an indication that book value is overstated? We cannot go and audit accounts and do fixed asset verifications. We cannot check utilisations and ponder policies. So what do we look for as clues as to these things?

Well, that answer is simple enough. Look for three co-existing conditions:

  1. Share is trading below NAV (obviously).
  2. Company’s Return on Equity (ROE) is below its Cost of Equity (CoE); in South Africa / on the JSE this often means that a single digit ROE will definitely fit this bill.
  3. The Company’s ROE is unlikely to recover to a period (or average) higher than or equal to CoE.

Why do these things matter?

Well, forget the balance sheet and accounting policies for a second. Imagine that the price you pay for a listed company’s share is the effective capital that you are giving to that company to generate a return on.

You need to be compensated for the risk you are taking, and that compensation should be at least the CoE of the company.

Thus, if the Company’s ROE is below its CoE, you will pay less than NAV such that the profits the Company is generating as a percentage return on your capital is at least equal to CoE.

For example, Company A has a NAV per share of 100cps and generates 5cps EPS. That is a ROE of only 5% (=5cps / 100cps), but its CoE is 15%.

Thus, in order for shareholders to be compensated sufficiently for holding this share, the share price should equal around 33cps (= 5cps / 15%). This means that the 5cps EPS on shareholder’s (floating) capital will equal a return of about 15%, which sufficiently compensates for the risk being taken.

Unfortunately, that also means that Company A’s share price is trading at a 66% discount to its NAV.

But does that mean that Company A’s share is cheap?

No. No, it does not. Unless Company A can ratchet its profitability upwards to where its ROE is closer to 15% (or unlock value some other way), Company A’s share will be both fairly valued and permanently below NAV.

Some real world debates being had on this fact include Grindrod (GND), Argent (ART), South Ocean (SOH), most of the construction sector, and a lot of the mining sector.

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