Berko: Explaining book value, other terms in finance

Dear Mr. Berko: I’m 78, and my spouse is 80. We bowl, play golf and bridge together, and I’ve become a decent tennis player since moving to the Villages from another development in Florida. This been wonderful place to live for years and, now it’s just an OK place to be. It seems that pushy, loud Northerners who move here lack decorum and good manners, which is forcing some older residents out, and that may include us. We heard that you moderated two investment forums at Top of the World recently and know some people there. So, what do you think of Kenneth Colen’s Top of the World near Ocala, Fla.? We’ve visited several times and it’s very pleasant and low-key.

And, finally, can you explain the following financial terms? I don’t understand them, but you use them quite a bit: (1) net profit margin, (2) price-earnings ratio and (3) book value. We have a fair portfolio of stocks (enclosed) and because we trust you, we hope that you would give us some ideas to improve our income and growth. Please don’t use our real initials because people we know read your column.

— XX, Villages, Fla.

Dear XX: The price-earnings ratio (P/E) is a metric that values a public company’s stock relative to its current earnings per share. This number is derived by dividing the current price of a stock by its per-share earnings. For instance, if ISKHA Corporation was trading at $30 and had share earnings of $3.00, then ISKHA would trade at a P/E ratio of 10. Basically, you would have to pay $30 to buy $3.00 of earnings. The significance of the P/E is a comparison with other public companies in the same business. If the P/E deviates strongly from the P/E of the group as a whole, you’ll want to know if this is good news or bad news.

Book value is the measure of a company’s net assets after subtracting its debts. If BIBBLE Corporation has $5.0 million in assets (land, building, equipment, patents, inventory, cash) and $2.0 million in debts (accounts payable, taxes, rents, lease payments) the book value is $3 million. Simple as Simone. After selling all of BIBBLE’s assets for $5 million and paying off all of BIBBLE’S debts of $2.0 million, the remaining $3 million is considered the book value. So, if there are one million BIBBLE shares outstanding, each of those shares is entitled to receive $3.00 in cash if the company liquidates. And as an investor, you would want to know how BIBBLE’s book value compares to others in the industry.

Net profit margin (expressed as a percentage) is the ratio of net profits to total revenues. In my world, this metric is one of the best yardsticks to identify the success or skill of a corporation’s management. So, the NPM identifies how much of each revenue dollar a company generates is translated into profits. So, assume that Hanks Homes sold 10 houses last year for $500 million. And after subtracting all costs — management, operating, marketing, sales, interest and raw materials totaling $450 million — from $500 million in sales, Hank’s Homes earned a profit of $50 million. And because this is expressed as a percentage, Hank’s Homes had a net profit margin of 50/500, or 10 percent. If Hank’s NPM continue rise, then that could be a darn good sign of superior management. Other metrics that I use and believe are important include revenue growth, free cash flow, capital spending, return on capital and return on shareholder’s equity.

I don’t know Kenneth Colen; however, I knew his father, Sidney, prior to his passing a few years ago, and I know they’ve built several large, beautiful and stunningly successful developments in Florida.

However, it’s my impression that a person’s satisfaction with his/her life depends more upon that person’s satisfaction with themselves rather than the ambiance of their milieu. I do know several folks who reside at Top of the World, and they’re happy as royalty.

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