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Abeyaar #2: Book Value


In today’s Abeyaar, we’ll try and look at a phrase knowledgeable people keep talking about: Book Value.

Amar: Oye, what is Book Value?

Akbar: Search for title on Amazon or Flipkart, it will show up. Did you know author gets only 10% of that? Just a waste of time to write books unless it becomes famous, but how will you know unless it…

Amar, interrupting: Abeyaar.

Akbar: What?

Amar: Book value of a company, man. I should search on Amazon?

Akbar: Whatay possibility. But no.

Amar: So what it is, boss? Why are you beating around the Clinton?

Akbar: Sorry, and wrong president. But anyway. You know a company, no? It has shares. Someone bought those shares at some point, say for Rs. 10 a share. Say it had 10,000 shares. So they paid Rs. 1 lakh.

Then they grew, and became profitable. They made Rs. 10 lakh net profit after tax, and rascals didn’t give dividend. So now the company has that initial 1 lakh plus the 10 lakh it didn’t give as dividend. So 11 lakh is the “shareholder’s equity”. Which contain 1 lakh rupees that promoters put in, plus the 10 lakh of “retained profit”.

Amar: I want also to buy this company’s shares at Rs.10 yaar.

Akbar: Your grandfather will give or what? Who will sell to you at Rs. 10?

Amar: Why, promoter bought at Rs. 10 no?

Akbar: So? You want communism you go off to Venezuela…Anyway, no one will sell you at Rs. 10 per share.

Amar: So how much?

Akbar: Think of it. 10,000 shares, and he made Rs. 10 lakh profit. So technically Rs. 100 per share as profit. If he can continue to grow at say 20% per year from now, you might give him a multiple of, say, 20x earnings. So Rs. 2000 per share is the price.

Let’s say you’re okay to pay that, and he issues you 5000 shares. So you pay the company 1 crore, and now you own 5,000 shares, promoter owns 10,000 and thus you own 33% of company.

Amar: Okay but I’m getting concerned about losing all this money.

Akbar: Yes, but let’s look at what happened. For that Rs. 10 share (“face value”) you just paid Rs. 2000. So you paid a “premium” of Rs. 1990 per share. For 5,000 shares that’s like Rs. 99,50,000 worth of “premium”.

This will go into the balance sheet as a “share premium reserve” which is on the liability side of the balance sheet, which has:

  • Shares issued of 15,000 shares at Rs. 10 face value = Rs. 1.50,000
  • Retained earnings at Rs. 10,00,000 (a “reserve”)
  • Share premium reserve of Rs. 99,50,000 (another “reserve”)

Total of this is the shareholder’s equity, or the “book value”, which is now 1.11 crores (11,1 million if you’re doing all the American thing)

Amar: How is this balanced! So many liabilities!

Akbar: On the other side, the company has assets – it has your 1 crore in cash. Retained earnings are also in the bank. So 1.1 cr. is there as cash only – the remaining money he probably went and bought some machinery or land or something (how else can you earn those 10 lakh in profits?) so that’s also an asset.

Effectively, since there are 15,000 shares, the book value per share is Rs. 740.

Amar: But I just paid Rs. 2,000 per share!

Akbar: Because bloody profitable. With your money he can make like 50 lakh per year profit next year, because he’ll buy new machines and all.

That, for 15,000 shares, is like Rs. 333 per share addition to book value every year. In some four years like this his retained earnings will then add a total 1,300 per share (assuming 50 lakh per year profit) in book value. The new book value is then equal to the 2,000 you have paid, and you still have a profitable business in your hand!

Now he has some 2.1 cr. in retained earnings. Lets say he decided to pay that out as a dividend. You effectively get 1/3rd of that, as you own 1/3rd of the company. So you get back Rs. 70 lakh out of the 1 crore you paid. And you still have 1/3rd of a business that makes 50 lakh a year!

Amar: But why pay dividend? Government will take 20% dividend tax then I am also taxed more.

Akbar: Abeyaar. That’s why they don’t go mad paying dividend. Leave it with company, it might need the money to grow.

Amar: Okay. So how does book value go down?

Akbar: If a company makes losses. Profits add to net worth and book value. Losses take away from it. Or if it pays out dividends, which will then reduce the book value to that extent.

Amar: What about bonuses? Splits?

Akbar: These are just financial jugglery. So the book value is the same because you don’t add any value to the company. But now, there are more shares, so the book value per share will fall in a bonus or a split. 

Amar: Can book value be negative?

Akbar: Of course it can. If a company borrows money and then loses more than its share capital plus reserves, it is technically negative net worth or book value. So that Rs. 1 lakh company could have taken a Rs. 5 lakh loan and then lost Rs. 3 lakh. That would make its net worth, or book value, a negative Rs. 2 lakh.

Amar: Whatay. So the lender will lose money now?

Akbar: Of course. This is, effectively, how a company goes bankrupt.

Amar: So the book value is a good estimate of how much a company is worth.

Akbar: Abeyaar.

Amar: Now what?

Akbar: You know all these things called banks no? Most times their book value is a figment of their imagination.

Amar: Why?

Akbar: Because they have to have a positive net worth, otherwise they can’t lend. When a loan defaults, it becomes an “NPA” and they can refuse to actually take the loss for a long long time. They’ll just take out 50% of the loss and leave the rest in as “net NPA”.

For instance, Bank of India has over 64,000 cr. of bad loans. It has some 36,000 cr. of “net NPA” (which means, after it has provisioned for the bad loans). It has a book value of Rs. 24,000 cr. – and if more of those already bad loans become worse, Bank of India will have no book value at all. So it’s book value is somewhere between -12,000 and +24,000 cr, and hopefully it hasn’t evergreened loans. (See: Abeyaar on Evergreening)

Amar: So a price as a low multiple of book value is not always good?

Akbar: Yeah. You have to trust the book. In many cases, such as banks, telecom companies and non-banking-finance-companies, the book value isn’t trustworthy because the companies themselves understate their losses.

Amar: So if you sell everything the company owns, and pay off all the debt, and they’ve actually not understated losses, you should get the real net worth.

Akbar: Sometimes you’ll get more. Because companies often don’t revalue land that they own (it’s kept at cost on books), and if you sold that land you’ll get a lot more. Sometimes you’ll get less because the company thinks it’s machines are worth X but when you try to sell them in the market second-hand they are actually worth X/2. But you’re on the right path.

Amar: Wait, what you’re telling me is: The book value is a nice thing as long as it’s trustworthy.

Akbar: As are most things in life….



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