The Value Of Assets

Published in Investing Strategy on 9 June 2009

Companies can be valued by many measures -- earnings, growth, cash. But it's a foolhardy investor who ignores the value of a company's assets.

In recent weeks I've taken a look at some of the various ratios that we can use to get a handle on the valuation of companies, seeing how share prices are influenced by a company's earnings, its expectations of future growth, and how it actually manages to rake in the cash.

But even taking those into account, similar-looking companies can still be afforded very different valuations, and there are clearly numerous other factors that influence an investor's choice. Today, I want to have a look at a few ratios that relate the price of a share to the value of the assets a company is sitting on.

If you were faced with two companies that could potentially manage similar turnover and profits, would you prefer to invest in a company that needs to tie up a lot of capital in expensive plant and machinery (like, perhaps an airline or a supermarket chain), or one that requires much less capital investment (say a software developer)?

Return on Capital

Either might make for a good investment, and the measures we have considered so far will not suffice to make useful comparisons. What we need, in addition, is some way to tie a company's profits to the amount of capital it requires to generate them.

And we do have such a measure, called the Return on Capital, or ROC. There are actually various versions of this ratio, but for the sake of simplicity we don't need to worry about the subtle differences between them. What matters is that the figure gives us a comparison of a company's net profits, expressed as a percentage of the book value of its invested capital.

Tesco (LSE: TSCO) for example, has a return on capital of around 14%, as it requires a lot of capital (in the form of stores, warehouses, vehicles, etc) in order to sell its large range of retail goods, and British Airways (LSE: BAY) manages around 16%. Alternatively, computer software develop Autonomy (LSE: AU) brings in a return on capital of around 70%, partly because the development of computer software doesn't require large factories and hundreds of stores.

Book value

But how can we relate things like the total assets a company is sitting on to its share price? We have a couple of ratios that are handy for that. Firstly, we have the Price to Book Value, or PBV, ratio. This is based on a company's book value, which is determined from its balance sheet by taking its total assets and subtracting its total liabilities. That leaves us with what, in theory, the company's assets might be worth if it ceased trading and sold everything off (but see below). 

If we then divide this by the number of shares, we get the book value per share (i.e. the amount of the company's stuff that a single share makes us the owner of). If we then divide the share price by this number (just as when calculating the P/E we divided the share price by the earnings per share), we get the PBV ratio.

But wait! Remember that bit about the closing-down sale scenario? Well, in reality, because of the things that a company can account for as assets and the way such things can be valued (for example, valuing intellectual property, such as ownership of software rights and patents, can be pretty much 'finger in the air' stuff), it's actually very unlikely that a company's full book value could be realised if it tried to sell it all at once.

Tangibles

To account for that, we also have what is known as the Price to Tangible Book Value, or PTBV, ratio, which is similar to the PBV but leaves out all those intangibles like intellectual property. Basically, it's a measure of things you can kick, and pack in boxes to sell should such need arise.

The PTBV will, of course, be higher than the PBV, as total book value will always be higher than tangible book value -- every company has some intangible assets on its books. The difference between the two values can say a lot about the nature of a company, and it is again interesting to compare Tesco with Autonomy.

Tesco has a PBV of about 2.2, and we'd expect quite a low value due to the company's need for lots of capital to run its business. Its PTBV, at 3.2, isn't a lot higher, suggesting, as we would expect, that most of Tesco's assets are of the tangible, kickable, variety.

If we now compare with Autonomy, we find a PBV of 4, echoing the fact that it is less capital-intensive than a supermarket chain. But much more interestingly, Autonomy's PTBV, at 20, is much higher, indicating that four fifths of the company's book value is intangible -- it's mostly the value of its software, its patents, and its intellectual know-how.

Which is best?

If we had to wind up both companies and sell off their assets, Tesco would fetch a good bit more cash per share, and though it's pretty unlikely to happen any time soon, such considerations are important to a lot of investors who like to focus on minimising their risks. By comparison, Autonomy will appeal more to investors keen on technological growth, who prefer to target higher potential rewards and take the risk that there is less to sell off should the worst happen.

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Comments

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GMichie 10 Jun 2009 , 10:36pm

One point I would raise regarding the valuation of any 'fixed asset' is the fact that values are generally much reduced in a fire sale situation and fall well below what the market value may have been deemed to be. Ultimately, any asset is only worth the value that a buyer is willing to pay. This applies to any company, and can result in a much reduced valuation for the creditor or shareholder at the end of the day.

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