In conventional investment advice, you sometimes see experts use book value to analyze an income investment, or any possible stock purchase.
Is Book Value Good For Income Investors
Is this a good idea for income investors? I don't believe so, for two reasons.
First, I suspect that many people don't understand the term. I've seen writers use it to mean what a company would be worth if it went out of business and sold off its assets. Not true.
Book value is an accounting term. It has nothing to do with current market value.
Companies Must Give Every Asset Some Value
It is the current price the company must keep on its books for an asset. In an ideal world, that would correlate closely with its market value, but we don't live in an ideal world.
When a widget company buys an asset such as a widget manufacturing machine, it must pay a price, obviously. The total price can be assumed to be the machine's current market price. That's because the company should not have paid more than the machine is worth, and no business would sell it to the widget company for less than the machine is worth.
Machines don't last forever, so the government and accounting principles allow the widget company to make an annual deduction of the widget machine's value. That's an expense that reduce the widget company's net income. It's called depreciation.
Government tax and accounting principles differ based on the type of asset. The IRS may allow the widget company to assume the widget machine has a seven year useful life.
Machinery Goes Downhill, So Companies Can Write This Off as an Expense
So if the widget machine cost $7,000, the widget company can write off $1,000 per year (I'm simplifying. It could be more complicated, but this is the basic idea.). What's left is the widget machine's book value.
So after one year, it would be $6,000, then $5,000 after two years, and so on, until its official book value is $0.
Depending on the Machine, Technology and the Industry, Its Real Value May Not Go Down for Many Years
But is its real, practical value $0? Depends on a lot of things. A lot of well-built machinery will run for many years if properly maintained. In the widget company continues to use it to make widgets, it may be a valuable business asset even though it has no official book value.
It may or may not have a market value. There's not a lot of resale value in used, highly specific manufacturing equipment, unless there are a lot of widget manufacturers who'd like a cheap widget machine. It may have only scrap metal value if sold.
And even if it operates perfectly, it may not be useful to the widget company. If that's an industry that requires new and better technology every two years, its useful life may be over even before it can be fully depreciated.
Then the company has to scrap it, and buy a new, up to date widget machine.
Companies are Not Required to Obtain Annual Market Appraisals of All Their Equipment
So there are companies with useful assets with no book values and companies with assets with book values that are technologically outmoded and not worth the time, energy and labor to use.
In the 1980s, corporate raiders would buy up entire companies because their physical equipment was worth more on the used market than the companies were earning. (See the movie WALL STREET). For some companies, that made sense.
But how much of Microsoft's value is tied up in physical equipment? It's not a big, successful company because of its company headquarters or the amount of computers and servers it owns. Its software programs are assets, but they would be worth a lot less if simply sold off piecemeal, without the expertise of the techies who create, maintain and continue to program improvements.
In a real sense, Microsoft's value is much more reflected in its labor costs than its depreciation expense.
So what does determine the worth of a company that's bought a lot of equipment?
Look at the Bottom Line
Why, that should be obvious -- its income.
A company is not worth the sum total it's spent on equipment. If that were true, companies could buy up a lot of equipment and just let it sit unused on the plant floor. That would save on energy, labor and supplies expenses.
No, companies are worth how much income they can use that equipment to produce. The Blue Widget Company and The Red Widget Company could buy and own the same widget manufacturing machines, but if Blue Widget uses it to make twice as much money as Red Widget, it's worth twice as much.
The second reason I don't recommend looking at a company's book value is that buying individual companies is too risky. You should be buying some kind of index of companies that pay dividends. Then, if the widget industry goes down the tubes, your retirement is not crushed.
The bottom line is, an income investment is worth what the bottom line shows.
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