Book value

Why is the Book Value of a company so important?

Book value (BV), sometimes called net book value is represented by fixed assets, plus current assets, less current liabilities, less long term liabilities.

That’s quite a mouthful of pluses and minuses. It’s best thought of as the other-side of the balance sheet – Equity (the equity will equal all of those items detailed in the first paragraph and so therefore represents BV).

As a shareholder, when you buy a share, you are buying a proportion of the equity in the business and therefore BV.  The efforts and decisions of management will either result in an increase or decrease in equity and the intrinsic value of what you hold will either be worth more or less.

The other benefit you may have in holding a share in a company is the receipt of a dividend.

If you owned 100% of a company your wealth would be increased by an improvement in the BV (or if you prefer the equity) and any dividends paid.

Since you cannot own 100% of a listed company, then the per-share value of the BV and dividend will be how you will determine whether a company is increasing shareholders’ wealth over the medium to long term.

This is quite a simple determination of wealth creation from a company and, over the medium to long term, takes account of normal earnings, share buy backs, exceptional costs, foreign exchange gains or losses, acquisitions and dividend pay-outs.

So as an example Reckitt Benckiser’s BV on 31 December 2007 was 334.7p per share and on 31 December 2012 was 823.3p, add to that the 5 years of dividend payments totalling 554p per share, then a shareholder has an increased wealth of 1042.6p (823.3p+554p–334.7p), which equates to a 5 year CAGR of 32.7% pa [5√ (823.3+554)/334.7].  A good example of a wealth creating business.

It is important to verify whether free cash flow per share over the period is close to the BV growth and dividends received per share.  A large discrepancy will tell you that earnings are not being converted in to cash or cash is being used on non-value enhancing operations.  For Reckitt Benckiser the free cash flow per share over 5 years has been 1002.6 per share and represents a 31.9% CAGR on the opening BV [5√ (1002.6+334.7)/334.7].  So earnings per share (either distributed or retained in equity) are being converted in to free cash flow per share and its use is value enhancing.