'Book value', 'balance sheet equity', 'net asset value' or whatever you want to call it is, for the reasons Professor Damodaran so beautifully articulates, inherently unreliable.
Repurchases of over priced stock (case study Apple which has destroyed half its equity value), asset write downs, lease accounting, carrying value of legacy assets (case study Coca-Cola, whose brand name and secret recipe don't feature on its balance sheet, but they would miraculously appear on the balance sheet of any business that acquired Coca-Cola), duration of depreciation and amortization schedules and so much more makes a huge difference to the number that appears in the company's books. In other words, it is a fiction.
This means that any measurement or ratio that includes the equity metric will, in isolation, be nothing more than noise. Perhaps this is why Buffett moved away from price to book ratios for valuation purposes around a decade ago.
However, these metrics are useful when used together because the noise created by the equity metric is cancelled out, revealing something useful. So, while return on equity may be of little value alone, in the context of price to book, it becomes useful. For instance, if a company is generating 20% ROE and using the same equity value it is capitalized at 2x book, then that ought to equate to an earnings yield of 10%. It no longer matters whether the equity number is accurate or not.
The take-away is that accounting practices were not designed to be used to value businesses and many accounting conventions are not fit for purpose as has been acknowledged by Professor Damodaran and others. Of this we can agree. This makes the metrics that flow from accounting practices dangerous for investors to rely upon, so only use these metrics with caution and in context.
The example of a company that expenses $30m of R&D, on an initial equity investment of $60m is wrong.
Profits in FY0 would fall to -$15m from +$15m without R&D expensing, reducing equity in FY1 to $45m, not $30m.
So profits in FY1 of +$15m would equate to a Return on Equity of 33%, not 50%.
It can be hard to keep track of the impact of flows vs. stocks without a full set of statements! Perhaps the missing part of the jigsaw is dividends, without which equity wouldn't remain at $60m, anyway.
This is a very well-written summary. Thank you.
'Book value', 'balance sheet equity', 'net asset value' or whatever you want to call it is, for the reasons Professor Damodaran so beautifully articulates, inherently unreliable.
Repurchases of over priced stock (case study Apple which has destroyed half its equity value), asset write downs, lease accounting, carrying value of legacy assets (case study Coca-Cola, whose brand name and secret recipe don't feature on its balance sheet, but they would miraculously appear on the balance sheet of any business that acquired Coca-Cola), duration of depreciation and amortization schedules and so much more makes a huge difference to the number that appears in the company's books. In other words, it is a fiction.
This means that any measurement or ratio that includes the equity metric will, in isolation, be nothing more than noise. Perhaps this is why Buffett moved away from price to book ratios for valuation purposes around a decade ago.
However, these metrics are useful when used together because the noise created by the equity metric is cancelled out, revealing something useful. So, while return on equity may be of little value alone, in the context of price to book, it becomes useful. For instance, if a company is generating 20% ROE and using the same equity value it is capitalized at 2x book, then that ought to equate to an earnings yield of 10%. It no longer matters whether the equity number is accurate or not.
The take-away is that accounting practices were not designed to be used to value businesses and many accounting conventions are not fit for purpose as has been acknowledged by Professor Damodaran and others. Of this we can agree. This makes the metrics that flow from accounting practices dangerous for investors to rely upon, so only use these metrics with caution and in context.
The example of a company that expenses $30m of R&D, on an initial equity investment of $60m is wrong.
Profits in FY0 would fall to -$15m from +$15m without R&D expensing, reducing equity in FY1 to $45m, not $30m.
So profits in FY1 of +$15m would equate to a Return on Equity of 33%, not 50%.
It can be hard to keep track of the impact of flows vs. stocks without a full set of statements! Perhaps the missing part of the jigsaw is dividends, without which equity wouldn't remain at $60m, anyway.
great take as always, thank you!
I can't get enough of these. so fundamental and explained so well.
Thank you, it was very interesting!