Book values

Financial statements can be deceptive in many ways. One of the most deceptive is the "book value" derived from financial statements. This is particularly so because a lot of "pundits" give it credence and it is used in many ratios to "evaluate" investments and is very popular with data miners.

Book values, except in the case of a small minority of companies like property companies and investment trusts that are asset based, bear little or no relationship to true values of the companies. The items on the balance sheet are the result of various transactions, recorded using double entry at a particular point in time, to the extent that they do not form part of the profit and loss account to that point in time. The assets and liabilities comprising the book value are mainly stated at historic cost though a few items therein may be stated at valuations.

In many of today's companies, their most valuable assets are not shown on the balances sheet and are therefore not included in the book value. Book values are meaningless in companies such as Microsoft, Google, GlaxoSmithKline, etc where their intellectual capital, internally generated goodwill, etc are much more valuable than the assets per their balance sheets but are not included therein.  In some cases, the book values are lower than their market capitalisations because the book values bear little relationship to their intrinsic values, e.g. Shell, Barclays, RBS, etc. This does not mean that these are under-valued by the market!

In Benjamin Graham's days, book values were more relevant as most companies then had significant investments in tangible assets and such assets comprised the bulk of the value of the company. The value of today's companies, other than asset based companies like investment trusts and property companies, is very different from the book values and there is no relationship between their intrinsic values and their book values. That is why Warren Buffet said "In all cases, what is clear is that book value is meaningless as an indicator of value" in his 2000 annual report.

I had discussed this in more detail, in 1998, on Motley Fool's BB - see http://boards.fool.co.uk/Message.asp?mid=5677919&sort=whole