Posted by cij on Dec 12th, 2008

In fundamental analysis of stocks, one of the most important numbers is the book value. Basically, book value is calculated by total assets minus intangible assets (patents, goodwill) and liabilities. Roughly speaking, it is the value you get if you liquidate the company.

But in times of debt deflation, how reliable is book value?

Remember that as we said before in Will deflation win?, such a deflation

… is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

When that happens, there is widespread liquidation of assets in the economy. Furthermore, buyers tend to be few as cash tend to be hoarded. In such an environment, it will be extremely difficult to realise the book value of a company if it has to be liquidated.

Therefore, when analysing a company’s balance sheet, be very sceptical of the carrying value of its assets, especially the very large and illiquid ones (e.g. buildings, plants). In times of deflation, the actual realisable value can be very far below the stated value. Therefore, the book value can be a very hollow number.