I recently made some notes on price to tangible book, competitive moats, and return on invested capital. The first note below is from a series of Twitter posts on the subject of price to tangible book; the other comments are just personal notes on investing:
- On the irrelevance of price to tangible book versus the relevance of debt to total assets (from a 2018 Twitter exchange with Tobias Carlisle): (a) reposted by Tobias Carlisle: "For stocks in the S&P 500, the correlation between price and tangible book value is just 14% [as of 2018]. This is a very big change from 25 years ago, when that correlation was 71%—or 5x stronger than it is now. Today the book value of a stock gives little clue as to its price.” -Bill Nygren https://twitter.com/acquirersx/status/1016994746185613312”; (b) my combined Twitter reply posts on the subject of price to tangible book: "@Greenbackd [Warren] Buffett has probably played a part in this change- based on annual letters he prefers unleveraged, asset light companies (less to maintain and low CapEx) that are generating lots of predictable cash flow; that’s probably what you’d want when buying a private business . . . Sine qua non of investing is 'what would you want if you were buying the whole business?’ You’d want few fixed assets to maintain/improve, low annual CapEx, little debt to pay off, and a strong, consistent history of FCF relative to price paid. This may be area where [Ben] Graham was a bit off, in terms of advocating for low price to tang book, because a low price to tang book screen tends to pull fixed asset heavy companies with high annual CapEx —> not what you’d want if you were a private business buyer. I think the best way to look at tangible book is by comparing debt to total assets—> a private business buyer may not care much about book value relative to price, but he does care about whether most of the company’s assets are encumbered/financed by debt (that he has to pay off)."
- The upside of a low price to tangible book is that it can help with downside risk in the event the company is liquidated (an unlikely event if you follow Graham's debt and current ratio criteria). Another upside to an asset heavy company with a low price to tangible book relates to barriers to entry — asset heavy businesses/industries are less attractive to new competitors and harder for them to break into.
- The downside of an asset heavy company with a low price to tangible book is that this kind of business is less attractive to potential acquirers because the acquirer gets stuck with the large annual CapEx needed to maintain, improve, and grow the business. Big CapEx makes growth more expensive and makes it more difficult for the company to quickly/flexibly change its business model — as needed — in response to changing competition and business conditions. Capital intensive businesses may also require more debt financing for the fixed assets needed to run the business. Finally, large CapEx eats up operating cash flow and returns on invested capital.
- The upsides and downsides of companies with capital intensive businesses seem to make price to tangible book a bit of a “wash” when analyzing a company — it doesn’t add much or detract much.
- When it comes to competitive “moats,” the best quantitative evidence of a moat is probably a consistent, stable history of positive free cash flow. Companies with consistent FCF are probably not competitively threatened in a serious way — otherwise their cash flows wouldn’t be so consistent. It’s interesting to think how a company can have consistent FCF, suggesting a competitive moat, and still be considered unattractive because it’s not growing fast enough or it's too capital intensive or it’s not earning high enough returns on invested capital. This probably explains why ugly companies with consistent FCF and apparent competitive moats can be cheap relative to market price.
- If returns on invested capital are too low (in the single digits) then reinvested profits are effectively wasted profits, meaning the investor doesn’t get the full benefit of his apparent investing bargain. An investment's earnings yield (earnings divided by market price) can look attractive, but this yield is reduced by management reinvesting earnings in low returning assets (rather than paying out earnings to shareholders through dividends or buybacks).
Regarding point six above, I wasn’t going to include any examples for fear my math or methodology might be off. I’ve since decided to include examples from my notes, with the warning that anyone reading these examples should follow their own methodology and do their own calculations — they should not blindly rely on my methodology. So the examples from my notes (with minor edits) are as follows:
- Even if the company maintains foolish reinvestment policies for a period of time, the company’s tangible book value (total tangible assets less total debt) should go up at a nice clip relative to the price I paid as an investor. If the company has a 20% earnings yield, a market cap of $1,000,000, and a tangible book value of $800,000, then every year the company fully reinvests earnings its tangible book goes up by roughly $200,000. If the company has invested capital of $600,000 and a low return on invested capital (ROIC) of 2%, then first year invested capital contributes another $12,000 of return. So even with a really low ROIC tangible book is going up significantly on an annual basis ($200,000 a year) — relative to the price I paid — and I’m getting 2% on $600,000 in invested capital tacked onto this. In this example tangible book would go to $1,000,000 the first year. The investor would have ownership rights on that book value if the company liquidated. If the company’s tangible book value can be liquidated for 40 cents on the dollar, then shareholders “earn” 40% of the $200,000 in reinvested earnings used to increase tangible book, or $80,000. Shareholders also earn $12,000 in ROIC (2% of $600,000 in invested capital). So in the first year shareholders get an investment return of roughly $92,000 ($80,000 in increased liquidation value plus $12,000 in ROIC), or a 9.2% return on the original $1,000,000 market cap. If you change the earnings yield to 10%, then tangible book increases by $100,000, from $800,000 to $900,000. If the investor “earns” 40% of increased tangible book, or $40,000, from reinvested earnings of $100,000, plus $12,000 in ROIC, then in the first year the investor ends up with $52,000 in investment return (reduced as appropriate by his ownership share of the company), or a 5.2% return on the original $1,000,000 market cap. These are conservative/pessimistic scenarios for an investor who buys a company with a high earnings yield and a low ROIC.
- Taking the 10% earnings yield example a bit further, if during the year the same company unexpectedly announces its intent to pay 50% of its earnings to shareholders through a one time dividend, then as an investor I get 50% of $100,000 in earnings, or $50,000 (reduced as appropriate by my ownership share of the company). I also “earn” 40% of the increase in tangible book, or $20,000, from the remaining $50,000 of earnings reinvested in the company, plus $12,000 in ROIC. So my first year return is roughly $50,000 in cash dividend, $20,000 in increased liquidation value from the increase in tangible book, and $12,000 in ROIC, for a total first year investment return of $82,000, or an 8.2% investment yield on the original $1,000,000 market cap. The point here is that small improvements in the payout policies of a low ROIC company can have a big, positive impact on my investment returns. In this example the company’s decision to increase its payout to 50% of earnings got me an investment return of roughly 8.2%, very close to the 10% earnings yield that I’d receive if the company increased its payout rate to around 100%.
The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.