Taking Book Value off the Shelf

The measure, lately out of fashion, is a deft way to gauge earnings quality.

Just about every valuation measure went out the window in the go-go '90s. Few, though, landed with a greater thud than book value. Once a favorite tool of Benjamin Graham, the investment guru who wrote the book on security analysis, it became unfashionable as a measure of a company's intrinsic worth. After all, book value was better suited to accounting for smokestacks and steel slabs than the more ethereal assets of the New Economy.

But now book value is getting a fresh look, not as a valuation tool but as a means of gauging earnings quality. Simply put, comparing the growth in book value to the growth in earnings "is a nice reality check," says Richard Maroney, director of research for Dow Theory Forecasts, an independent investment newsletter.

In theory, at least, book value is what would be left over if the company were to go out of business that minute. The number-crunchers calculate book value by beginning with total assets, then subtracting long-term debt and other liabilities and preferred stock. Some analysts also take out intangible assets such as goodwill, trademarks, and patents to calculate the "tangible book value," but that's not necessary for this sort of analysis. Once you figure the book value, in millions or billions, you divide it by the number of shares outstanding to arrive at book value per share, which is easy to compare against earnings-per-share reports.

Sure, the decade of mergers and acquisitions, corporate restructurings, and share repurchases has made book value a sometimes squishy number. Book value can increase as a result of mergers, and it can go up if a company has just sold a lot of new equity. But the most regular contributor to the growth of book value is retained earnings, or earnings after dividends. That's why monitoring the changes in book value is worthwhile.

How does it work? Maroney starts with a company's compounded average annualized growth rate of operating earnings over three years and then checks on whether book value is growing along the same trajectory. In the past three years ending August, 2002, for example, Walgreen's operating earnings have grown 16.5% on average; book value has kept pace, increasing at a 21.4% rate during that period. In the current fiscal year, operating profits at Walgreen's have risen 13.3% in the first three quarters, while book value is up 11.8%, suggesting solid earnings.

The method sometimes sends up a red flag on companies that may be reporting strong earnings, but where the underlying trend in book value indicates the opposite. A classic case is BellSouth (BLS ) says Maroney. From 1990 to 1996, BellSouth's earnings went from 85 cents to $1.27, a 6.9%-a-year average annual increase. But during that period, "book value went from $6.63 to $6.68, basically showing no change," Maroney says. Or take a look at AutoZone (AZO ), an auto-parts retailer. Over the three fiscal years ending in August, 2002, earnings rose an average of 34.9% a year, while book value per share fell 9.9%.

Don't look for absolutes. Book value growth doesn't need to match earnings growth, but it ought to be close. Also, it's a matter of degree: A company with 25% earnings growth and 22% book value growth is in a better position than one whose earnings are expanding by 6% and whose book value is up only 3%. This reality check doesn't help when numbers are fraudulent, as with Enron or WorldCom.

For all their shortcomings, says J. Edward Ketz, associate professor of accounting at Pennsylvania State University, book values are worth a look. At a minimum, says Ketz, they "bring some credibility to the [earnings] numbers." In these nervous times, that's no small measure.

By Robert J. Rosenberg

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