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Investing Books / Security Analysis -- the book
|Subject: book value vs. intrinsic value||Date: 1/6/2003 9:15 AM|
|Author: scrim1||Number: 1576 of 1936|
Gateway's shares trade at a level valuing the company equivalent to its cash, which is roughly $1 billion. That cash cushion gives Mr. Waitt, who owns 30% of the company's shares, room to try yet another restructuring. But the company is expected to report 2002 revenue of $4.2 billion, less than half its peak two years ago. And despite a promise to eke out a profit one quarter this year, few analysts who follow the company now forecast one. "The reality is this is probably the fourth or fifth new strategy in as many quarters," says Joel M. Wagonfeld, an analyst at Banc of America Securities.
Mr. Waitt is in no danger of losing his job. In addition to being chief executive, president and chairman of the board, he is also the largest individual stockholder. And some on Wall Street think the company could rebound if PC sales re-emerge from the doldrums. Stan Majcher, at value-investors Hotchkis & Wiley Capital Management, says it's a bargain. "It's trading close to net cash," he says.
Assuming this company doesn't burn through any more cash, it is trading near its cash value, which means the market is saying this business is worthless. The brand is worthless and the knowledge and investments Gateway has made over the last two decades is worthless.
I think some value investors confuse the difference between what Buffett considers value investing and what others consider value investing. Some characteristics that most investors associate with "value" is a low P/E, a low P/Book, or a high yield. Buying a company with a low p/e and low p/b ratio doesn't make for a rational investment. Neither does buying one with a high p/e or p/b ration. Buying $1 of economic value for 60 cents is. Buffett's investment philosophy is common sense investing or intrinsic value investing in my opinion.
Here's Buffett's view of the difference between book value and intrinsic value.
We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value - the measurement that really counts. Book value's virtue as a score-keeping measure is that it is easy to calculate and doesn't involve the subjective (but important) judgments employed in calculation of intrinsic business value. It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings.
Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.
An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child's education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.
At Berkshire, at the beginning of fiscal 1965 when the present management took over, the $19.46 per share book value considerably overstated intrinsic business value. All of that book value consisted of textile assets that could not earn, on average, anything close to an appropriate rate of return. In the terms of our analogy, the investment in textile assets resembled investment in a largely-wasted education.
Now, however, our intrinsic business value considerably exceeds book value. There are two major reasons:
(1) Standard accounting principles require that common
stocks held by our insurance subsidiaries be stated on
our books at market value, but that other stocks we own
be carried at the lower of aggregate cost or market.
At the end of 1983, the market value of this latter
group exceeded carrying value by $70 million pre-tax,
or about $50 million after tax. This excess belongs in
our intrinsic business value, but is not included in
the calculation of book value;
(2) More important, we own several businesses that possess
economic Goodwill (which is properly includable in
intrinsic business value) far larger than the
accounting Goodwill that is carried on our balance
sheet and reflected in book value.
Goodwill, both economic and accounting, is an arcane subject and requires more explanation than is appropriate here. The appendix that follows this letter - "Goodwill and its Amortization: The Rules and The Realities" - explains why economic and accounting Goodwill can, and usually do, differ enormously.
You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.
Keynes identified my problem: "The difficulty lies not in the new ideas but in escaping from the old ones." My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets.
Buffett writes the following about his investment in Berkshare Hathaway:
It probably also is fair to say that the quoted book value in 1964 somewhat overstated the intrinsic value of the enterprise, since the assets owned at that time on either a going concern basis or a liquidating value basis were not worth 100 cents on the dollar. (The liabilities were solid, however.)
So it might make sense to invest if the company were to liquidate, but not if the company planed to continue to operate. This is why investing in McDonalds because of the land is a value trap. The intrinsic value will be determined by the profits generated by the McDonalds concept.
From another letter.
When Buffett Partnership, Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway 21 years ago, it had an accounting net worth of $22 million, all devoted to the textile business. The company's intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value.
He goes on to say..
We remained in the business for reasons that I stated in the 1978 annual report (and summarized at other times also): "(1) our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labor has been cooperative and understanding in facing our common problems, and (4) the business should average modest cash returns relative to investment." I further said, "As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."
It turned out that I was very wrong about (4). Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.
Some comments on another textile company.
For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.
Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington's basic commitment to stay in textiles, I would also surmise that the company's capital
decisions were quite rational.
Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 -- on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.
Here are some interesting figures..
There is an investment postscript in our textile saga. Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.
The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.
Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.
Ponder this: the economic goodwill attributable to two paper routes in Buffalo - or a single See's candy store - considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.
If the price they sold the equipment for was less than the removal costs, why did they decide to sell it? Why not just let it sit there. Also, why didn't they move the equipment to Mexico or China and take advantage of the cheap labor? Could they have created a sustainable business that way and still employ some of their old workers to handle sales and marketing and whatever else that needed to be done inside the States? If such a business were sustainable, I doubt it'd be a high ROE type of business. He still could have saved a few jobs.
This is from another letter.
Back when Berkshire's book value was $19.46, intrinsic value was somewhat less because the book value was enirely tied up in a textile business not worth the figure at which it was carried. Now most of our businesses are worth far more than their carrying values
Gateway is interesting, because most of its book value is liquid cash. There is little dispute as to what the cash is worth. If Gateway is able to burn little cash and reach profitability, then there should be decent upside in the stock, since you are buying the business for free.
Would someone buy Gateway at these levels (and would management sell)? IBM or HP might buy Gateway at these prices for the market share (GTW has 6-7%) and they could use Gateway's efficient manufacturing capabilities so they could take on Dell..? Could there any value to a HP or IBM if they decided to buy Gateway?
Legg Mason is one of the largest shareholders.
From the GTW 2001 Annual Report:
Finally, we will continue to refine our cost structure, specifically by improving our variable costs. Sure, we're spendind more on marketing our value and product leadership. That's essential to growing our busines. But we have to continue improving things like cost of customer acquisition, cost of fulfillment and cost of support, without sacrificing overall quality or customer satisfaction.
And, as we grow, we'll continue to get increased leverage from our fixed cost structure and expect to emerge as a healthy, profitable company in 2003. We're already well on the way.
Who knows if he's right, but Wall Street has them doing -$0.36 per share next year.
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