Understanding Book Value (Net Tangible Assets) on a Balance Sheet
The balance sheet concepts of book value, or net tangible assets, and shareholders' equity are not quite the same thing. To find a company's book value, you need to take the shareholders' equity and exclude all intangible items.
This leaves you with the theoretical value of all of the company's tangible assets which are those assets that can be touched, seen, and felt as opposed to things such as patents, trademarks, copyrights, and customer relationships. It is this distinction that causes book value to be referred to as net tangible assets.
Why Net Tangible Assets Are Important
The amount of net tangible assets a company has on its balance sheet is of particular importance despite it being frequently overlooked by inexperienced investors and even major financial portals. In fact, depending upon the source of your financial data, you may not even have net tangible assets calculated for you, requiring you to pull the annual report or Form 10-K filing yourself to calculate it.
(In the event that happens, calculating book value is easy. All you have to do is take the total assets and subtract all of the intangible assets such as goodwill. What remains consists of the nuts and bolts of the company; the buildings, computers, telephones, machinery, pencils, and office chairs.)
Book Value Is Useful in Estimating the Quality of a Business
Book value can be extraordinarily useful in estimating the quality of a business. In fact, it's a lot easier to get rich by investing in an excellent business, though there can be intelligent things to do when looking at so-called bad businesses. A good business will generate after-tax profits of somewhere between 12% and 25% on book value.
An excellent business can generate after-tax profits of anywhere north of 25% of book value. The sustainability of these returns is highly important. What makes a company such as Hershey so incredible as a long-term position is that it has proven capable of producing mouth-watering results for not just years or decades, but generations spanning the 19th, 20th, and now 21st century.
This is a modern discovery that only really came into the mainstream sometime over the past thirty or so years. Prior to that time, it was generally thought the more assets a company had, the better. It was a series of successful value investors who demonstrated the folly of this approach.
They showed that not only do asset-intensive businesses tend to produce lower returns on equity, but they can also get slaughtered during periods of high inflation. This is because the property, plant, and equipment needs to be replaced at ever-escalating nominal prices, as opposed to something like a software company that can simply raise prices without a huge adjustment to the cost structure or invested asset base.
The Relationship Between a Company's Assets and the Profit It Generates
You probably already realize this on some level, even if you don't know you do. A scenario might demonstrate the reason. Let's say Company A earns $10 million a year and has $30 million in assets. Company B earns the same $10 million but has $50 million in assets. It is generally understood that a relationship exists between the number of assets a company has and the profit it generates for the owners.
If you wanted to double the earnings of Company A, you would probably have to invest another $30 million into the company. After the reinvestment, the business would have $60 million in assets and earn $20 million a year.
However, if you wanted to double the earnings of Company B, you would have to invest another $50 million into the business, which would double the assets. After the reinvestment, the business would have $100 million in assets and generate $20 million a year. What does that mean?
Company A would have to retain $30 million in earnings to double its profits. Company B would have to retain $50 million to get the same profit! That means that Company A could have paid out the difference, in this case, $20 million, as dividends, reinvested it in the business, paid down debt, or bought back shares!