Exploring the limitations of book value

A piece in today's Wall Street Journal looks at the decline of so many home building stocks and the metric that sent so many value investors chasing a falling knife: Book Value. Book value is a defined as a company's assets minus its liabilities, and can give a quick indicator of whether a stock is really cheap.

But what got investors who chased home builders into trouble was that the companies ending up having to take write-downs because of declining land values, and they ended up in a classic value trap: The stock just wouldn't stop becoming a better deal!

Investors will continue to argue about the future of the home builders. But the issue that has some value investors scratching their heads is this: When companies write-down their book values as their businesses decline, how helpful can book value really be?

Adding to this, a decline in stock price can actually lead to a write-down of intangible assets, as recently happened at companies including PlanetOut (NASDAQ: LGBT) and Lenox Group (NYSE: LNX). So what good is book value?

It's very good. It's so good in fact that super-investors like Carl Icahn and Warren Buffett used it to screen for cheap stocks early on in their careers. Buffett's best returns came with his investment partnership based on the principles of Benjamin Graham, which are all about book value and liquidation value.

I frequently use book value to screen for very cheap stocks. But most of them turn out to be junk, and they deserve to be cheap. Book value is a great way to find potentially interesting stocks, but strong bottom-up research must follow.