(Keep remembering, open-market purchases of the stock take place at 125% of book value.)

from Warren Buffett – Letter To Shareholders 2012 on Rap Genius


Here, Buffet seems to be applying the tools and metrics of investing in financial institutions to the world of non-financial operating companies.

Since financial institutions are largely holders of “price-able” securities, the book value of equity (total assets less total liabilities) does a pretty decent job of approximating the market value of equity. (The equity really does derive most of its value from being the residual claimant on the firm’s assets.) For these institutions, “premium or discount to book value” is the most-frequently-used “multiple” that takes into account the qualitative idiosyncrasies that might make you pay a bit more or less than average to hold that company’s equity. So most financial institutions trade around a price to book value ratio of 1.0x. (More specifically, between 0.5x and 1.5x.)

Solvent operating companies, on the other hand, are valued not by a ratio of their book value of their equity but by their earnings power (ie EBITDA multiples and P/E ratios) and regularly have price to book value ratios of 2x or greater.

Buffet’s real confusion here, I think, is a result of the fact that while Berkshire does have a lot of non-financial operating companies in its portfolio, Berkshire itself, as a holding company rather than an operating company, has a book value profile more similar to a financial institution since its primary asset value comes from holding securities rather than having built the operations from the ground up.

The difference is reflected in Goodwill, which adds to the measured assets of a company once Berkshire has bought it, and removes any premium-to-book value the company’s valuation may have included.

As an example, Wal-Mart currently trades at 3x book value ($240bn market cap and $80bn book value) but if Berkshire were to buy Wal-Mart for $240bn tomorrow, Berkshire would add the $160bn delta as goodwill and therefore Wal-Mart’s price to book value as a subsidiary of Berkshire would become 1.0x (or maybe a bit higher if Buffet were convinced he got a great price on the deal and Wal-Mart is actually worth $260bn or something).

Given that a large percentage of Berkshire’s operating companies were purchased recently and are mature businesses, book value should decently approximate their intrinsic value. (In other words: they should not be be valued at the 2x+ price-to-book value ratios common for most operating companies.) Which all serves to explain why Buffet is used to measuring Berkshire’s operating companies similar to financial companies and forgets that normal companies do not get valued at premiums to their book value and definitely due not get premiums to their cash holdings.

Non-financial companies trade at a premium to book value when they’ve managed to put together a unique and differentiated set of assets that can earn above average rates of return. Since cash is basically a pure commodity, its portion of book value does not earn a premium. (This is, for instance, why calculations of Total Enterprise Value ignore the size of a company’s cash balance).

Obviously, at the extreme, if the company’s only asset was cash, the company would not earn a premium to book value and would simply trade at the value of the cash balance.

More to the point, a company with $50 of cash and $50 of other net assets trading at 25% of book value (valued at $125) would not, as Buffet suggests, be valued at $62.50 if it dividend its $50 of cash. In reality, the company’s valuation would drop to $75 (which was its TEV all along) and its premium to book value would be 150%.

A final way of looking at this is that if you really believed a company’s premium-to-book value is not related to cash as a percentage of book value, you would continually sell new shares and hold cash on your books. (If draining cash decreases the company’s intrinsic value, bringing cash into the company must increase intrinsic value.)

Take our company with $100 of book value valued at $125 and assume there are 100 shares of stock, each valued at $1.25. If we simply had the company issue another 100 shares in exchange for $125 we would now have a book value of $225 ($100 + $125), a market value of $281.25 ($225 * 1.25) and a share price of $1.41 ($281 / 200). In this world why not sell 10,000 shares, or a million?

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