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Book Values, Liquidation Values, and Market Values

Why is PepsiCo selling at $34 per share when the stock of Pfizer, listed below PepsiCo, is priced at $331вЃ„16? And why does it cost $25 to buy one dollar of PepsiCo earnings, while Pfizer is selling at 40 times earnings? Do these numbers imply that one stock is a better buy than the other?

Finding the value of PepsiCo stock may sound like a simple problem. Each year PepsiCo publishes a balance sheet which shows the value of the firm s assets and liabilities. The simplified balance sheet in Table 3.2 shows that the book value of all PepsiCo s assets plant and machinery, inventories of materials, cash in the bank, and so on was $22,660 million at the end of 1998. PepsiCo s liabilities money that it owes the banks, taxes that are due to be paid, and the like amounted to $16,259 million. The difference between the value of the assets and the liabilities was $6,401 million, about $6.4 billion. This was the book value of the firm s equity.4 Book value records all the money that PepsiCo has raised from its shareholders plus all the earnings that have been plowed back on their behalf.

Book value is a reassuringly definite number. KPMG, one of America s largest accounting firms, tells us:

In our opinion, the consolidated financial statements . . . present fairly in all material respects, the financial position of PepsiCo Inc. and Subsidiaries as of December 26, 1998 and December 27, 1997, and the results of their operations and their cash flows for each of the years in the 3-year period ended December 26, 1998, in conformity with generally accepted accounting principles.

But does the stock price equal book value? Let s see. PepsiCo has issued 1,471 million shares, so the balance sheet suggests that each share was worth $22,660/1,471 = $15.40.

But PepsiCo shares actually were selling at $33.94 at the end of 1998, more than twice their book value. This and the other cases shown in Table 3.3 tell us that investors in the stock market do not just buy and sell at book value per share.

Investors know that accountants don t even try to estimate market values. The value of the assets reported on the firm s balance sheet is equal to their original (or historical ) cost less an allowance for depreciation. But that may not be a good guide to what the firm would need to pay to buy the same assets today. For example, in 1970 United Airlines bought four new Boeing 747s for $128 million each. By the end of 1986 they had been fully depreciated and were carried in the company accounts at residual book value of $200,000 each. But actual secondhand aircraft prices have often appreciated, not depreciated.

5 In fact, the planes could have been sold for upwards of $20 million each. Well, maybe stock price equals liquidation value per share, that is, the amount of cash per share a company could raise if it sold off all its assets in secondhand markets and paid off all its debts. Wrong again. A successful company ought to be worth more than liquidation value. That s the goal of bringing all those assets together in the first place.

The difference between a company s actual value and its book or liquidation value is often attributed to going-concern value, which refers to three factors: 1. Extra earning power. A company may have the ability to earn more than an adequate rate of return on assets. For example, if United can make better use of its planes than its competitors make of theirs, it will earn a higher rate of return. In this case the value of the planes to United will be higher than their book value or secondhand value.

2. Intangible assets. There are many assets that accountants don t put on the balance sheet. Some of these assets are extremely valuable to the companies owning or using them but would be difficult to sell intact to other firms. Take Pfizer, a pharmaceutical company. As you can see from Table 3.3, it sells at about 15.8 times book value per share. Where did all that extra value come from? Largely from the cash flow generated by the drugs it has developed, patented, and marketed. These drugs are the fruits of a research and development (R&D) program that since 1985 has averaged about $500 million annually. But United States accountants don t recognize R&D as an investment and don t put it on the company s balance sheet. Successful R&D does show up in stock prices, however.

3. Value of future investments. If investors believe a company will have the opportunity to make exceedingly profitable investments in the future, they will pay more for the company s stock today. When Netscape, the Internet software company, first sold its stock to investors on August 8, 1995, the book value of shareholders equity was about $146 million. Yet the prices investors paid for the stock resulted in a market value of over $1 billion. By the close of trading on that day, the price of Netscape stock more than doubled, resulting in a stock market value of over $2 billion, nearly 15 times book value. In part, this reflected an intangible asset, the Internet browsing system for computers. In addition, Netscape was a growth company. Investors were betting that it had the know-how that would enable it to devise successful follow-on products.

Market price need not, and generally does not, equal either book value or liquidation value. Unlike market value, neither book value nor liquidation value treats the firm as a going concern.

It is not surprising that stocks virtually never sell at book or liquidation values. Investors buy shares based on present and future earning power. Two key features determine the profits the firm will be able to produce: first, the earnings that can be generated by the firm s current tangible and intangible assets, and second, the opportunities the firm has to invest in lucrative projects that will increase future earnings.

5 This is partly due to inflation. Book values for United States corporations are not inflation-adjusted. Also, when the accountants set up the original depreciation schedule, nobody anticipated how long these aircraft would be able to remain in service.

BOOK VALUE Net worth of the firm according to the balance sheet.

LIQUIDATION VALUE

Net proceeds that would be realized by selling the firm s assets and paying off its creditors.