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Book value
Book value of a company's stock, as the name suggests, looks at the value of each share on the basis of what's in the book - ie, what's in the balance sheet of the company. As we know, balance sheets are drawn up by recording the value of assets at historical cost of acquisition less accumulated depreciation. Value of all assets, as recorded in the books of account, subtracted by all external liabilities gives the net worth of the company, which belongs to the shareholders. This net worth (as recorded in the balance sheet) divided by number of shares gives you the book value of each share.
For accountants, there are some more technical twists in the tale, such as preference shares etc which need to be accounted for before arriving at a precise book value per equity share. However, for the sake of conceptual clarity, let's just stick with the simple calculation of book value as described above.
How useful is book value as a measure in determining the fair value of a stock? Well, that depends on two key factors:
How important are the physical assets of the company in determining its ability to generate profits, and -
Whether the physical assets are appreciating assets, depreciating assets or assets whose value does not change with inflation/market forces
Let's take the first point. Take a business of power generation. The business depends entirely on the power plant that has been set up and the power transmission infrastructure that has been set up. The ability of the business to generate profits is critically dependent on and is materially influenced by the level of physical assets that the business owns. Intangible assets like brand, intellectual property and such like have little place in determining ability of the business to generate profits. It is the physical assets and the ability of the management to optimally utilize these physical assets that determines profitability of the company.
Take, on the other hand, a software firm. Its physical assets are relatively modest - what determines its ability to generate profits are intangible qualities including quality of its software development team and their ability to complete projects accurately and on time, reputation of the firm and its track record which gives it pricing power and so on. The value of computers on the books, especially post depreciation, will be tiny. Book value of such a firm - where physical assets do not materially influence ability to generate profits - will therefore not be a relevant measure to determine fair value of the stock.
Now, lets get to the second point. If physical assets are indeed a critical factor driving ability to generate profits in a company, the next question is whether these assets are appreciating or depreciating assets. If a real estate company bought large tracts of land years ago, which have appreciated significantly in value, but are still recorded in its balance sheet at original cost, the book value of shares will no longer be a useful indicator to determine fair value of the stock.
So, when is book value a fair indicator of the value of a company's stock? If there is a business whose profitability critically depends on its physical assets, and those assets do not either appreciate or depreciate significantly, then book value can be a very useful indicator of fair value of the stock. A good example is banks - especially those who rely heavily on traditional lending based businesses. A bank's ability to generate profits is critically dependent on the loan book it has. The loan book - the assets - don't depreciate or appreciate - they remain constant. If the bank does not have a sizeable fee income business, then the book value of its shares can be a useful indicator of fair value of its shares. Why do we say that low fee income is important for book value to be a good indicator? Because fee income does not involve sweating of physical assets. Fee income is advisory in nature - it depends on factors such as skilled treasury and distribution teams, brand value and other such intangibles rather than only the size of the loan book.
Here is a table that gives you a comparison of book values and current market prices (and thus the price to book ratio) of a few companies in different businesses:
If book value were to be a good indicator for a business, then a Price/Book Value ratio of 1 would signify fair value. Below 1 would be undervalued and over 1 would be overvalued. Take our two PSU banks in the table - both are quoting at marginally above book value. As we discussed earlier, PSU banks are a good segment for using P/BV as the valuation metric. Same time last year (in Nov 13), these stocks were available at a P/BV of around 0.6. They were clearly undervalued, according to the valuation metric most suitable for them. Now, they are around or mildly above fair value, after the big run up of 2014.
Private sector banks have a higher P/BV and are still not regarded as expensive because they have found ways to generate profits beyond just their asset base (their loan book). As fee income keeps rising, P/BV as a measure for such banks becomes less relevant. P/E becomes more relevant.
Take the 2 IT stocks. Do P/BV values of 5.95 and 10.52 make them expensive. No, because P/BV is not the right measure to value IT businesses, which derive profitability from the quality of their manpower, robustness of their processes and ability to win large international deals - none of which need huge investments in fixed assets.
Similar is the case with FMCG companies whose brands are their biggest profit drivers, not the factories where soaps are produced. They could well outsource soap production to a contract manufacturer, keep low assets on book, and maximize profits by leveraging the strength of their brands.
Replacement value
Replacement value, as opposed to book value, considers the cost that will be incurred to replace the existing set of assets of a firm, or to replicate the assets if a similar new business were to be set up. Replacement value per share then follows the same computation of book value per share. The numerator changes - to reflect replacement cost of assets rather than book value of assets, while the denominator remains the same - number of shares.
Lets say there is a power plant that was set up 10 years ago at a cost of Rs. 500 crores, and the depreciated value of assets on the books is now standing at Rs. 100 crores. For sake of simplicity, let us assume no other assets and no external liabilities. Net assets of the company at book value is Rs.100 crores. If paid up capital is Rs. 10 crores comprising of 1 crore shares of Rs.10 each, the book value is Rs.100 per share (10 times the paid up value). Now, if the market price of the shares are Rs.300, would you say the stock is overpriced? Before rushing to a conclusion that it is, you may want to find out what the replacement value of its power plant is now. The last 10 years have been highly inflationary in our country, and consequently, if an entrepreneur were to set up a similar power plant today, he would need to sink in an investment of say Rs. 2500 crores. Now, the interest cost and depreciation on such a large base will mean that he will need significantly higher realizations on the electricity he is selling, in order to make any profits. This factor can enable the existing power plant to raise its tarrifs, and make much larger profits. Using old assets that are in good working condition, in a capital intensive business, in an inflationary environment, means chances of making super normal profits. The existing power plant should not be valued on the basis of its book value, but on the basis of replacement value of its assets.
Going back to our example, if the replacement value of its assets is now Rs.2500 crores, its replacement value per share is now Rs. 500 although the book value is only Rs. 100 per share. At a current market price of Rs. 300, it is a bargain. Look at it this way, a new entrepreneur who wishes to set up a new power plant can well be tempted to mount a takeover bid on the existing company, because at Rs.300 per share, he gets a power plant far cheaper than setting up a new one. That's where replacement value is best used in stock valuation.
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