Book Value Versus Earning Power
by ARTHUR W. JOYCE
THE widespread acceptance of conservative common stocks as desirable vehicles for investment is accompanied by conflicting opinion with regard to a suitable yardstick with which to measure their fair market value. An ultraconservative tone is apparent in the post-panic discussions, which urge a drastic modification in certain rules of thumb heretofore used in this process of evaluation. Despite the c omplexities of common-stock analysis, it is a fair statement that the two factors most widely considered as influencing the price at which a common stock should sell are its asset or book value and its earning power. (The writer considers the factor of efficient management to be of primary importance, but believes it is sufficiently reflected in earning power for the purpose of this brief paper.)
There appear to be two distinct schools of thought upon this subject, the one insisting that book value is of vital importance in determining fair market value, while the other emphasizes the superior importance of earning power. Adherents to the book-value school usually declare that market value ought not to be much more than book value, irrespective of earnings, whereas adherents to the earning-power school believe that a stock is entitled to sell at a certain multiple of its net earnings. In either case, the question as to what the ratio should be seems to the writer to be distinctly secondary to the deeper question as to which of these two factors is the more dependable, and thus the safer guide to follow.
In the first place, book value means simply asset value, and denotes the proportion of the assets of the corporation applicable to each share of its stock. As one of a small army of stockholders, the owner of these assets is almost certain not to want physical possession of them, because they are likely to be worth less in his hands, and because in all probability he would not know what to do with them if he had them. Moreover, with the exception of purely financial corporations, it is practically impossible for the stockholder to get the indicated book value of his share converted into cash without tremendous shrinkage. There is a vast difference between book value and liquidating value. Successful corporations, with the exceptions noted, cannot be liquidated for a cash figure anywhere near the indicated book value of their common shares, while liquidation under receivership is usually disastrous.
The book value of a common stock is simply an interesting statistical fact. It is useful mainly for purposes of comparison among corporations of similar capital structure, but is not necessarily final even for this purpose. It does not constitute a reliable base from which to estimate fair market value, for two reasons: first, because of the basic differences in types of common stocks; secondly, because there is not of necessity any fixed relation between book value and market value, even among stocks of similar type. The element of management efficiency prompts the latter conclusion, for if management A can consistently outperform management B under identical circumstances, obviously management A’s stock becomes the more valuable, irrespective of book values.
That book value fails to be indicative is aptly illustrated in the case of many stocks of New England textile mills during the past few years. Their stockholders must be painfully familiar with the facts, since they have seen their shares sell for substantially less than their indicated book value (in many cases for less than their net quick asset value). The physical assets of these mills were largely unimpaired, but ownership of them became a doubtful privilege, simply because these assets, in themselves, are worth very little in the absence of earning power. Many stockholders of once prosperous street railways also have come to understand that assets without earning power are not far removed from liabilities in their practical effect upon investors.
It should be perfectly clear that earning power is always directly related to the fair market value of a common stock. It has long been held as a conservative premise that an established industrial common stock with stable earnings is entitled to sell for ten times its net earnings. A stock that sells for ten times its net earnings is probably selling for between fifteen and twenty times its dollar dividends (the theory here being that it probably pays out in dividends about one half to two thirds of its net), which automatically brings its dividend yield between 5 per cent and 7 per cent on such market value. This reasoning is certainly conservative, and represents the moderate end of a range of opinion holding that the multiple of net earnings to use in evaluating established common stocks should be much higher than ten — say twenty. The question is not whether the rule of ten is conservative, for that is obvious, but rather under what conditions can or should a higher multiple be used. The answer lies in the type, the stability, and the capacity for sustained growth of earning power. In developing the following case for earning power, it will be helpful to include parallel comments upon book value, in order that the latter may be assigned its proper place.
One of the best-known but least-mentioned types of earning power is that of compound interest. Money placed under its sphere at 41 per cent, compounded semiannually, doubles itself in about 15i years. The quiet magic of this progress is inherent in every savingsbank book. Fortunately, savings banks are essentially philanthropic institutions, so that this earning power of compound interest is available free, otherwise there can he little doubt that their particular type of earning power would justify a modest premium. It may be unusual to think of a savings-bank book as having book value, or market value, yet it has both. Its book value is quite literally the value indicated upon the book itself, while its market value exists at its logical trading centre, which is at the counter of the issuing bank. These two values are identical, partly because the earning power of compound interest thus involved is quite definitely limited to a relatively low rate, but mostly because possession of it is not subject tocompetitive bidding.
Another well-recognized type of earning power is what might be called corporate earning power, by which is meant the ability of a corporation to earn on its capital a larger percentage than could be earned from that same operation separately conducted on a small scale by any one of the stockholders. Expert management, large capital, mass production, and so forth, are things which redound to the advantage of this type of earning power, and render it attractive to large numbers of investors. Unlike compound interest, however, corporate earning power is not limited to a fairly fixed rate around the normal 5 per cent, nor is participation in its benefits available in the fairly unlimited way that compound interest is available through savings banks. On the contrary, corporate earning power, especially as exemplified in the common shares of well-established successful companies, is purchased by investors under competitive conditions. Under normal conditions the market value of these shares is based upon their earning power as expressed in the form of immediate dividend return around the normal 5 per cent, plus the probability that this return may be increased in the future.
The most potent type of earning power is also probably the oldest known type — banking earning power, by which is meant the earning power of a common stock as it is vastly augmented by inheriting, from senior capital (such as bonds and preferred shares), the excess earnings of the senior capital beyond its fixed cost. Every commercial bank is a perfect illustration of this type of earning power, in which the relatively small amount of capital and surplus receives the benefit of earnings derived from a vastly larger amount of deposits. The existence of such senior capital ought never to be a matter of chance, however, but rather the result of careful analysis of its appropriateness for a given corporation. There are conditions under which the presence of senior capital would indicate poor banking judgment, exactly as under different conditions its presence in large volume is highly desirable, perfectly logical, and distinctly conservative. Wherever it exists, it must necessarily be supported by relative stability of the earning power of the corporation, in order that the fixed charges of such senior capital may be adequately protected. It is in wide use, and must be given due consideration when comparisons are made as to the ratios existing between book value and market value. A simple illustration will conserve space in proving this point.
Consider two corporations, of identical size, business, and management efficiency, and let it be understood that each corporation earns 10 per cent upon its total capitalization, net after deducting all expenses, taxes, and depreciation, as follows: —
|A CORPORATION||B CORPORATION|
|Capitalization Bonds, 5%||$10,000,000||none|
|Common stock (par value and book value $100||10,000,000||$20,000,000|
|Net earnings @ 10%||$2,000,000||$2,000,000|
|Deductions Bond interest||500,000||none|
|Net available for common||$1,500,000||$2,000,000|
|Percentage earned on common||15||10|
Book values are identical, yet clearly A stock is worth more than B stock, because its earnings are 50 per cent greater. Under normal conditions, no one ought to expect to be able to buy A stock at its book value— indeed, by altering the capital structure of A corporation conservatively, the net earnings upon A stock can readily justify its selling for two or three times its book value.
It occurs to the writer that many investment trusts advance as an argument for the purchase of their common shares the fact that their market price is maintained within 1 or 2 per cent of their book value. In such eases, it is usually a fact that these trusts have no senior capital, being financed entirely by common shares. This being so, it follows quite logically that such shares are priced at their book values as a top price, for the essentially simple reason that it is difficult to see how they can possibly be worth more, unless it be a very small premium for management. The argument that such shares sell at their book values is sound, but it in no sense sets this level as a limit beyond which other common stocks, as part of an entirely different capital structure, should not sell.
Earning power, rather than asset value, must be the most vital factor in influencing market value of common stocks of successful corporations, the proof of which lies in the fact that the market value of common stocks of unsuccessful corporations is entirely uninfluenced by their book value.