Apr

27

Logo of American and Foreign Power CompanyHow does a company like DuPont have a book of 5 bucks a share when it's been earning 2.00 a share for 100 years? Part of it is that it pays dividends of 85% of earnings. The kind of stock my grandfather would have recommended for me along with American & Foreign Power. Couldn't go wrong with that 10% dividend — until they were nationalized. That corporation was another of his favorites besides Union.

Rocky Humbert comments:

DuPont has been a poster child for the Modigliani-Miller theorem. They've been increasing leverage and buying back stock for years, which — depending on the price paid — can cause a perverse and self-reinforcing decline in book value. And even with a low book value, about 61% of their shareholder equity is goodwill. But their ROE looks very sweet at 25+%.

Ironically, DuPont was originally a dynamite manufacturer. Dynamite funded the Nobel Prize. Modigliani-Miller won the Nobel prize in 1985. So the circle is unbroken. 

Yishen Kuik writes:

A more extreme example is Colgate Palmolive, which at one time had negative book value. The shareholder's equity portion is still a negative number, and the persistent accumulation of retained earnings has since brought book value back to positive. It still probably has some fantastic price to book ratio.

Rocky Humbert adds:

The following stocks all have market caps over $1 Billion and negative book values:

F, LO, MJN, DISH, Q, AZO, CVC, LLTC, FNM, OZM, MCO, FRE, ADS, DNB, UAUA, NAV, CQP, VHI, PALG, RGC, AMR, ITMN, EK, TCO, CHH, BEI, SGW, GRA, WTA, HLS, JE, SBH, INCY, SD, UIS, TEN, DEXO, ARM, RAD, THRX, VGR, TLB, WMG, TMH, LCC, GLBC.

The significance of this phenomenon is left as an exercise for the reader.

Sushil Kedia comments:

Historical Accounting leaves disproportionate under-priced assets due to inflation on the books making book-value appear to be very small in comparison to earnings, for very old and profitable companies that distribute large dividends.

For younger companies in fortune businesses such as exploration, new molecule discovery etc. anticipations of a breakthrough can have large market caps and low hard assets.

Franchise businesses, including those that thrive on brands such as Colgate, customer loyalty concepts etc. will have a very large proportion of assets that are intangible and never appear on the books of accounts making book values very small.

Companies that have dominantly assets with large depreciation rates allowed too will have lower than average b/p price ratios.

Companies that have taken over larger companies would have a lot of ethereal assets termed as "goodwill" making low b/p ratios again.

Phil McDonnell writes:

I note that Colgate has a return on equity of 90% according to Yahoo data. Big Blue reported today. They currently have a respectable 77% ROE. They are paying an increased dividend and buying back stock. To me it is interesting that the large stable companies that are doing this also have fairly large goodwill entries, as Sushil noted. For example Colgate has about $2B in goodwill on the books. Usually this means they paid too much for an acquisition. Too much means they paid more than the book value of the assets acquired. But in the case of stock buyback if the company buys its own stock at market, which is higher than its book value per share then presumably that shortfall is recorded as goodwill. If the stock rises or has risen in the past then that may mean there is hidden asset value on the books in some sense.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008.

Steve Ellison observes:

I am looking at Oracle's 10K. Oracle used $3960 million of cash in 2009 to repurchase shares. On the statement of stockholders' equity, Oracle reduced common stock by $550 million and reduced retained earnings by $3410 million. Thus the effect of share repurchases was to reduce stockholders' equity, but this effect was more than offset by the increase in stockholders' equity from net income of $5,593 million. 

Sushil Kedia comments:

If Inflation Accounting seminars held by so many august Accounting Bodies all over the world in the last two decades could not decipher how it could really be done, assume for a moment at some point it will be done correctly.

But then the book-keepers that produce the inflation estimates and keep revising them invariably all over the globe (I guess all gummints are at least alike on this parameter whether they be Capitalists or Communists) are also just book-keepers.

So, this one conundrum will never be solved.

In recent decades there have been some high-brow management consultancy firms that are peddling ideas of Brand Valuation. But then if a company could own a brand worth a Billion Dollars and make only continuous losses their ability and talent at producing so much red is eventually leaving a value on the table of that Brand at just a risk adjusted present value aggregate of these losses as a negative number only. Brand Valuation as an Accountancy tool has no place in the Accounting World, save for nice trips to Bermuda for such conferences.

Replacement Cost Theories have been used and rather mis-used to pamper the valuations of cash-loss generating companies on an idea that it would cost so much to build this same factory today at the extreme end of bull-runs.

Then they say Cash is King. But the King everywhere in this Universe has been only trashing cash ever since it was invented. So, we go back to the beginning of this note. All roads lead to Rome, in the world of Fundamentals.

So what Fundamentals are we talking about at any point and under any framework?

At least the price followers, even if prices are manipulable and get manipulated every now and then are having a far simpler illusion of suffering from knowledge and the best part is this manipulation keeps coming regularly, tick by tick. The follower of price action recognizes if there is an incentive to an economic activity, it is happening already. So, irrespective of whether prices are manipulated or they are not, the stimulus to any system of taking decisions is consistent.

The Fundamental Manipulations are erratic, supposed to be non-existent until an Enron comes by every now and then while they are happening throughout erratically and then with an endless battery of ideal world assumptions the whole Art of Fundamental Analysis has such elegant and consistent formulae for everything. The quantitative screens in each and every idea in the universe of fundamentals is so self-sufficing and yet this form of art never could get known to be any variation of Quantitative Finance.

I am not against Fundamentals at all, but just wish my elegantly consistent brothers and sisters in this art form acknowledge the fool's paradise they are keeping building.


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