Chapter 4 The Value of Common Stocks 79
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difference between the value of the assets and the liabilities was $135 billion. This was the
book value of GE’s equity.
Book value is a reassuringly definite number. Each year KPMG, one of America’s largest
accounting firms, gives its opinion that GE’s financial statements present fairly in all mate-
rial respects the company’s financial position, in conformity with U.S. generally accepted
accounting principles (commonly called GAAP). However, the book value of GE’s assets
measures only their original (or “historical”) cost less an allowance for depreciation. This may
not be a good guide to what those assets are worth today.
One can go on and on about the deficiencies of book value as a measure of market value.
Book values are historical costs that do not incorporate inflation. (Countries with high or
volatile inflation often require inflation-adjusted book values, however.) Book values usually
exclude intangible assets such as trademarks and patents. Also accountants simply add up the
book values of individual assets, and thus do not capture going-concern value. Going-concern
value is created when a collection of assets is organized into a healthy operating business.
Book values can nevertheless be a useful benchmark. If a financial analyst says, “Holstein
Oil sells for two times book value,” she is effectively saying that Holstein has doubled its
shareholders’ past investments in the company.
Book values may also be useful clues about liquidation value. Liquidation value is what inves-
tors get when a failed company is shut down and its assets are sold off. Book values of “hard”
assets like land, buildings, vehicles, and machinery can indicate possible liquidation values.
Intangible “soft” assets can be important even in liquidation, however. Eastman Kodak
provides a good recent example. Kodak, which was one of the Nifty Fifty growth stocks of
the 1960s, suffered a long decline and finally filed for bankruptcy in January 2012. What was
its most valuable asset in bankruptcy? Its portfolio of patents, which was put up for sale. The
present value of the patents was estimated, perhaps optimistically, at $3 billion.
Valuation by Comparables
When financial analysts need to value a business, they often start by identifying a sample of
similar firms as potential comparables. They then examine how much investors in the com-
parable companies are prepared to pay per dollar of earnings or book assets. They see what
the business would be worth if it traded at the comparables’ price–earnings or price-to-book-
value ratios. This valuation approach is called valuation by comparables.
Table 4.1 tries out this valuation method for four companies and industries.^5 Let’s start
with Dow Chemical. In December 2014, Dow’s stock was trading at $42.71. Earnings per
share (EPS) for the latest 12 months were $3.05, giving a P/E ratio of 14.0. Dow’s market–
book ratio (price divided by book value per share) was P/B = 2.3.
P/Es and P/Bs for several of Dow’s competitors are reported on the right-hand side of
the table. Notice that Dow’s P/E is generally higher than the P/Es of these comparables. If
you didn’t know Dow’s stock price, you could get an estimate by multiplying Dow’s fore-
casted EPS by the average P/E for the comparables. The estimate would be somewhat low (at
3.05 × 12.6 = $38.43), but nevertheless helpful. On the other hand, Dow’s P/B is much lower
than for the comparables. If you had used the price-to-book ratios for these companies to value
Dow, you would have come up with a substantial overestimate of Dow’s actual share price.
Look now at the Union Pacific railroad and the four comparables in Table 4.1. In this case the
P/B ratios for the comparables are lower than for Union Pacific (an average of 3.5 versus 4.6).
The average P/E for the comparables is a little higher (23.5 versus 20.7). Thus valuation by com-
parables would not give you exactly the right price for Union Pacific, but you would be close.
(^5) Be extra careful when averaging P/Es. Watch out for companies with earnings close to zero or negative. One company with zero earn-
ings and therefore an infinite P/E makes any average meaningless. Often it’s safer to use median P/Es rather than averages.