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Why Do Some Businesses Trade Above Their Book Value?

When Warren Buffett bought a chocolate manufacturer back in 1972, he and his partner Charlie Munger offered a price tag of US$40 million for the business, which turns out to be the famous See’s Candies.

At that time, Buffett’s offer was US$25 million above See’s book value. He felt the price he was paying was already too high and the offer would be his last.

But after Buffett and Munger acquired the business, See’s Candies started to grow at a rapid clip: The candy maker’s pre-tax profit ballooned from US$4.2 million in 1974 to US$42.4 million by 1990 (a 10-fold jump in just 16 years!) That wasn’t the only great thing about See’s Candies. The company had managed to achieve that strong earnings growth with a relatively much smaller increase in working capital from US$7 million to US$25 million (meaning to say that Buffett didn’t have to fork out too much cash to reinvest into the business). In those 16 years, See’s also returned more than US$400 million in dividends for Buffett and Munger.

The experience he got after the purchase of See’s Candies ultimately led Buffett to discover the true meaning of an economic franchise.

Thing is, not all businesses are created equal. Some require huge capital investments in order to earn a return while some businesses have such strong economic franchises that they can generate huge returns even with minimal reinvestment. As a result of their economic characteristics, the latter group of businesses tend to trade at a premium – sometimes a large premium – over their book value.

A quick scan through the universe of Singapore-listed shares show that many are trading significantly higher than their book value. Some of the ones with the highest price-to-book multiples include Silverlake Axis Ltd (SGX: 5CP)Sarine Technologies Ltd (SGX: U77)Dairy Farm International Holdings Ltd (SGX: D01), and Singapore Exchange Limited  (SGX: S68).

Share Price to book value (7 October 2014)
Silverlake Axis 12.2
Sarine Technologies 11.3
Dairy Farm 9.91
Singapore Exchange 8.08

Source: S&P Capital IQ

Do the aforementioned quartet of companies have a strong economic franchise like Sees Candies? In other words, do they deserve to be trading at a large premium over their book value?

The questions above are important to answer because investing in a company with a high price to book value comes with a risk – that of the economic franchise of the company being illusory. Companies with illusory economic franchises can grow strongly when times are good, but when the economic environment worsens, any economic moat which they appear to have would disappear. When that happens, the results are often not pleasant for investors.

To find out if a company truly possesses an economic franchise, check out a company’s pricing power. If the company is able to raise prices on its products or services without losing market share, it might point toward the presence of an economic franchise. Another useful check would be the resilience of a company’s business in an economic slowdown – it’s a great sign if the company’s business does not seem to be affected in times of crises.

If you are able to find a company which score well on those two checks, you might just have discovered the next See’s Candies.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own any of the companies mentioned.