I think it is safe to say that people are familiar with Warren Buffett at this point. The investing public generally knows that he is a value investor, and has very strict investment criteria. However, I have not heard much discussion of perhaps his most ubiquitous, but difficult-to-describe, criteria for investing: book value.
Buffett himself measures his own firm's intrinsic value by monitoring its change in book value, even though he admits that book value can only be a proxy for the value of Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B).
Still, why don't we as investors look more closely at change in book value of our firms? It seems to make a great deal of sense, if we idolize Buffett as much as we claim.
To be more explicit, it's not even about just book value growth. It is about price-to-book-value growth. How is the price of your company performing relative to the change in book value? If book value is skyrocketing, but so is the stock price, then maybe there is not so much value left in the stock. But say price change does not even keep up to change in book value on a 1-to-1 ratio, doesn't that scream buy?
I would argue yes, although that statement comes with the caveat that no two balance sheets are the same, and I don't respect goodwill the same way I respect cash when coming up with a reasonable value for book value of shareholders' equity.
Want some examples of this phenomenon? Look no further than Berkshire. Based on Morningstar estimates, the BVPS (book value per share) has risen from $29.22 in 2002 to $70.21 by the end of fiscal 2011. That is good for a 140% gain in book value over roughly 10 years. What has the stock done? Only a 64% gain. So, if price were following book value 1-to-1 (assuming the preceding period did not include a wild overpricing of the stock), the price should be some 75% higher than it currently is.
Why is this? Buffett has claimed himself that since Berkshire holds several private businesses whose value can't be marked to market daily like his investment portfolio, and investors undervalue them. It sounds plausible, and the guy seems pretty smart, so I trust him.
Following book value rather than other metrics gives the investor some reasonable assurance of the value of their holdings, with oftentimes a built-in margin of safety because book value, especially tangible book value, has some liquidation value. On this basis, Berkshire makes for a terrific choice in stocks because of the tangible value of its assets, which are currently underappreciated in the market.