All serious investors should read Warren Buffett’s annual letters. They’re masterclasses on how to make money…

At the beginning of each Berkshire Hathaway yearly report, Buffett gives his latest thoughts on investing and the markets.

And his 2019 letter was no exception…

The Oracle of Omaha wrote about his usual fare: why he likes stock buybacks… the power of compounding… and even how corporations can essentially get an interest-free loan from the government (it involves deferred income taxes).

But this year’s letter also contained a big surprise—and it reads like heresy to many investors… Buffett is ditching “book value” for measuring the value of companies:

Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice. The fact is that the annual change in Berkshire’s book value—which makes its farewell appearance on page 2—is a metric that has lost the relevance it once had.

Now, you might think this change isn’t a big deal. But for value investors, ditching book value is like the NFL adding the forward pass—it’s a game changer.

And even if you don’t follow Buffett, you need to know why he’s getting rid of a value measure once considered sacrosanct. Other investors are likely to follow his lead, which could have an impact on your portfolio…

Paradigm Shift

For decades, Buffett has used the price-to-book (P/B) ratio to value companies. The ratio compares a company’s stock price to the value of its underlying assets.

Buffett’s mentor Benjamin Graham first popularized the ratio in his 1934 classic, Security Analysis. In the book, Graham argued that you should only buy companies trading at a P/B ratio less than 1.5. Anything above that is too expensive.

For years, Buffett used this measure to value his Berkshire Hathaway empire.

But a recent study from research firm O’Shaughnessy Asset Management found the P/B ratio to be worthless…

From 1983 to 2015, the most expensive 20% of stocks (based on P/B ratio) beat the market by 0.2% a year on average. The cheapest 20% underperformed by 0.2% a year.

So you would’ve been better off buying stocks with a higher P/B ratio for that period—a clear sign that the ratio is no longer a measure of future returns.

That’s probably why Buffett is giving up on it. In his letter, he says it’s “increasingly out of touch with economic reality.”

Here’s why…

Modern companies are much different from their predecessors of 100 years ago.

In the past, companies needed to build factories, buy supplies to manufacture products, and assemble products people wanted. These capital-intensive businesses (like auto or appliance makers) had lots of assets that would go into their book values.

But today’s powerhouse companies are built in the digital realm.

Amazon, Facebook, Google, and Netflix don’t need factories, assembly lines, or heavy machinery to operate. Since they’re asset-light, they don’t have large book values. And this makes them look expensive on that basis.

Take Apple, for instance…

It has a P/B ratio of 10—much higher than the 1.5 ratio Graham recommended. But based on profits, Apple is trading at a 14.6% discount to the market.

A Different Way to Measure Value

Moving forward, Buffett won’t use any ratios to value his business. He’s determined that the best measure of success is share price. If the stock is up, he did well. And if the stock is down, he didn’t.

Again, that’s a radical shift for a value guy like Buffett. He once said of Mr. Market:

[T]he poor fellow has incurable emotional problems. At times, he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times, he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him.

So if the P/B ratio is no longer relevant to valuing modern companies, what is?

If you’re a value investor, the price-to-earnings (P/E) ratio is a good place to start. We often use this measure here at PBRG to find quality companies trading at discounts.

Generally, the lower the P/E ratio, the better… But don’t just compare a company’s P/E ratio to the overall market’s. You should also compare the P/E ratios of companies in the same industry. That’ll give you a better measure of relative value.

Another measure we use (and one of my favorites) is the price-to-free cash flow (P/FCF) ratio. Free cash flow is the money a company has left over after paying all its bills. In other words, it’s net income, or profits.

Companies with high free cash flow can use that money to fund additional growth. Or if they’re shareholder-friendly, they can return that cash to stock holders in the form of dividends or buybacks.

Most brokers have stock screeners allowing you to search for companies with low P/FCF ratios. But don’t blindly rely on just one metric. Dig a bit deeper and make sure the company is still a good business before investing.

Regards,

Nick Rokke
Analyst, The Palm Beach Daily

P.S. Are you planning to follow Buffett’s lead and change the way you value companies? Let us know right here

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