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Chapter 4. Less Than Book Value? What A Bargain!

Chapter 4. Less Than Book Value? What A Bargain!

How Helga Learned to Mistrust Accountants

Helga, a psychologist, had always wanted to be an accountant. She bemoaned the fact that her discipline was subjective and lacked precision, and wished that she could work in a field where there were clear rules and principles. One day, she read an article in the Wall Street Journal on Global Telecom, whose stock, the report said, was trading at half its book value. From her limited knowledge of accounting, Helga knew that book value represented the accountant's estimate of what the equity in the bank was worth. “If a stock is trading at less than book value, it must be cheap,” she exclaimed, as she invested heavily in the stock.

Convinced that she was secure in her investment, Helga waited for the stock price to move up to the book value of equity. Instead, it moved down. When she took a closer look at Global Telecom, she learned that its management had a terrible reputation and that it had either lost money or made very little every year for the last 10 years. Helga still kept her faith in the accounting value, convinced that, at worst, someone would buy the firm for the book value. At the end of the year, her hopes were dashed. The accountants announced that they were writing down the book value of the equity to reflect poor investments that the firm had made in the past. The stock price no longer was lower than the book value, but the book value had come down to the price rather than the other way around. Helga never yearned to be an accountant again.

Moral: The book value is an opinion and not a fact.


The book value of equity is the accountant's measure of what equity in a firm is worth. While the credibility of accountants has declined over the last few years, many investors continue to believe that accountants provide not only a more conservative but also a more realistic measure of what equity is truly worth than do financial markets, which these investors view as subject to irrational mood swings. A logical consequence of this view is that stocks that trade at substantially less than book value are undervalued and those that trade at more than book value are overvalued. As you will see in this chapter, while this may sometimes be true, there are many stocks that deserve to trade at less than book value because they have made poor investments, high risk, or both.


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