Is book value really an outdated measure for stocks?

The chart below is an updated version of one presented by Goldman Sachs chief strategist David Kostin before the pandemic, which has stuck in my mind ever since. US sector valuations appear to have organized themselves around a largely outdated accounting metric in the form of book value.

First, the chart. The x-axis is price-to-book (P/BV) and the y-axis is profitability via return on equity (ROE). Each industry sits closely on a trend line (the variance calculations support this) which, depending on your ideas about correlation and causality, could imply a connection between the two accounting metrics.

The problem is that few analysts or investors use book value anymore. This measure was ideal for Depression-era industrial companies to capture the liquidation value of a company that almost certainly owned machinery that could be auctioned off.

Today, the assets of the index-dominating companies are intangible – such as patents, installed software bases, brands, customer relationships and sheer size. The value of intangible assets in the event of liquidation is much more difficult to determine, so book value is largely ignored.

Market sectors with high real asset content are all grouped in the bottom left of the chart – with low P/BV and low return on equity. These include utilities, real estate, commodities (the commodities sector in the US is not dominated by precious metals, unlike Canada) and possibly energy.

The upper right area of ​​the chart with high P/BV and high profitability unsurprisingly shows the technology sector and also the consumer goods sector dominated by Amazon.com. The communications services sector in the lower third of the trend line is an interesting case. It includes the asset-weak but highly profitable Alphabet Inc. and Meta Platforms Inc., but profitability is dragged down by the asset-rich AT&T Inc. and Verizon Communications Inc., as well as various traditional media.

This is more of a chart for reflection than a sole source for asset allocation decisions; it is too crude and there are the accounting issues mentioned above. But it seems that despite the lack of interest in book value multiples (bank stocks might be an outlier here), market sectors in the world’s largest stock market have organized around them and are achieving higher P/BV multiples relative to return on equity.

There may be a reason for the apparent relationship between P/BV and ROE that I have not considered, making the chart so predictable it is eye-rolling. Otherwise, it may be that investors as a whole have inadvertently created a new equilibrium that could help approximate the fair value of stocks.