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Subject:  Book Value, PIV-ER and CHK Date:  2/2/2007  12:07 PM
Author:  hheiserman Number:  1280 of 1817

Book value is a company's earnings since inception that have been reinvested back into the business in the form of working capital, fixed capital, or other assets, rather than paid out as dividends or used to buyback shares. In other words, this is your money! So, add book value to operating value (sum of present value of earnings during the forecast and terminal periods) when estimating intrinsic value.

Of course, if book value consists entirely of goodwill, the company has lots of debt, and free cash flow is heading south, then you may never get your piece of the pie. Also, before you buy a stock, verify all numbers using the 10-K and or 10-Q. Yahoo makes mistakes.

My PIV-ER spreadsheet tells me the percentage of a firm's intrinsic value that comes from book value, the percentage from the forecast period, and the percentage from the terminal period (all adding up to 100%). The bigger the percentage of book value as a percentage of intrinsic value, the more carefully you want to inspect the quality of the firm's assets.

One of the classic mistakes investors make when using pro forma's to estimate real worth is buying a company where a large percentage of intrinsic value is from the terminal period. When you use a sanity test like the one I described in the preceding paragraph, you can see how much of intrinsic value is explained by current assets and earnings during the forecast period. The closer this percentage is to 100%, the better.

Consider Chesapeake Energy (CHK), which is mentioned in some posts above. If we believe a) its TTM earnings of $1.89 billion is what the company can earn across an entire cycle (business, commodity), b) analysts are correct about the five-year growth rate of 13.6% (which we'll use in our High forecast for years 1-5), and c) the $18.85 of book value does not need to be reduced by contingent liabilities like operating leases, employee stock options, etc. (it may, I need to check), then d) 17% of its $109 intrinsic value is due to the $18.85 of book value, 59% is due to earnings over the next ten years, and 24% due to terminal period growth. When I see that 77% of a company's intrinsic value is due to current assets and/or earnings over the next ten years, then I am confident the stock represents good value.

(I use a 10% discount rate above. If I used an 11% rate, then IV is $97. A 12% discount rate yields an IV of $88.)

A further point about book value…sometimes a company has hidden assets. In CHK's case, the per-share book of $18.85 may be understated if the market value of its natural gas reserves is higher than the amount listed on the balance sheet. If so, then CHK's corporate net worth rises, pushing intrinsic value up with it. (Phil Durell has done some good work on CHK for Inside Value, so if you are a subscriber read his write-up and check out the discussion board.)

For CHK, I get an intrinsic value of $109, PIV of 27%, and an ER of 264%, based on data from Yahoo Finance. I want to emphasize this is just a drive-by valuation, and is subject to revision after further study. But if this PIV-ER estimate is approximately right and since my portfolio's current PIV-ER is 49%-136%, then I should sell my worst-scoring PIV-ER stock and buy CHK. Like you, I want to keep pushing my portfolio towards the best possible risk-reward score.


p.s., Thanks for all the recs. It is gratifying to learn so many people find this idea useful.

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