Book Value

Submitted by Share Trading on 10 March, 2010 - 19:57

The term “Book Value” refers to the value of an asset that is recorded in its balance sheet which usually is the cost of the asset less depreciation, amortisation and impairment costs that are related to the asset.

Determining the Actual Stock Price- Why is This So Important?

When it comes to the share market, often investors want to buy stocks or shares at a lower price. Now in order to do so, an investor needs to determine how much the shares of a particular company should worth. There are various ways to calculate the actual price of a stock which helps an investor to understand whether the current price of a stock is way too high or too low. By determining the actual stock price, you can avoid facing loss and also can come across a real bargain.

Determining the Value of a Company

One of the most common ways of determining the value of a company is by finding out what would be the price of that business if it was going to be sold. If all the assets of that company were liquidated, how much would these assets fetch?

Now one thing you need to keep in mind, when a company goes for selling its assets after getting liquidated, it can sell only the tangible assets- the ones that can be seen and felt. These tangible assets can be the buildings, land, accessories, furniture and vehicles along with cash, investments and money that are owed to the company (receivables).

Though factors like intellectual property, brand name, goodwill, copyrights, trademarks and patents are also considered as assets, they cannot be flogged on the market easily. The intangible assets of a business become worthless when the operation gets liquidated.

After the liabilities of a company are paid, now you can determine the book value of its shares. This is the value that the investors will get from the shares if the company stops operating straight away. To sum up, if a business or a company gets liquidated and flogs all its assets and subtracts intangible assets and its debts, the money that the investors or shareholders of that company will get is the BOOK VALUE.

Calculating the Book Value

In order to determine the book value, you need to have access to the balance sheet of the company. Then you will need to deduct the intangible assets and liabilities from company assets. Now to find out the book value of an individual stock, all you need to do is divide the book value with the number of shares that are on issue.

Now let’s take an example to have a proper understanding about the calculation of book value. Let’s assume that ABC Company has $300 million worth in assets and $225 million worth of liabilities. So the book value is going to be,
$300 million - $225 million = $75 million.

Assuming that the company has 20 million shares on issue in the stock exchange, an individual ABC share will worth:
($75 million / 20 million) = $3.75.

Benjamin Graham, who is the mentor of Warren Buffet and considered as a master of value investing prefers to go for the shares of those companies whose stock prices are lower than their book value.

Determining Whether the Share is Over Valued or Under Valued

Price-To-Book Ratio or P/B ratio is considered as an effective measure to determine whether the price of the stocks of a company is properly justified or not. In case of calculating the P/B ration, you will need to divide the closing price of the shares of a company by its most recent book value per share which can be found in the quarterly or annual statement of the company. This ratio is also known as the Price/Equity Ratio.

The higher the ratio is, the higher the premium is going to get that the investors are willing to pay for the company above the book value. Now if the ratio is low, then this means the business does not obtain much value or the company got it all wrong. If you see that the P/B ratio of a business is below 1, this means (theoretically) that the stocks of that company are selling at a price lower that the value of its liquidated assets. Means the company will worth more when it shuts down than when it is operating.

Many traders including Benjamin Graham used to prefer low P/B stocks considering that such stocks are potential for gaining share price in the future. Sometimes you will find a stock taking a major hit from the market unjustifiably something that takes the price of that stock to the bottom of its price chart for a certain period of time. Investing in such times can turn out to be profitable and P/B ratio can help an investor to identify shares that are undervalued. However, a low P/B ratio of a company stock can also refer to the fact that something is not right with the company. So you need to make your moves carefully in such cases.

The Limitations of this Ratio

The fact is, book value metric is not a perfect method and comes with various pitfalls. One of the major drawbacks of book value is determining a reliable amount of the total assets on the balance sheet. This is really not that easy to calculate the value of a company building that is more than 60 year old or the machines that has operated in the factory of that company for a decade or so.

The book value shows how much a company originally spent for it assets, less the depreciation for tear and wear. Sometimes you may find assets that depreciated to zero after being held in the record for a long time while on the other hand comparatively new assets can worth more on the balance sheet in case they were sold outright on the market. This can skew the book value of a company significantly.

In addition to this, the book value ratio is not that effective when you analyse the shares of companies that has fewer tangible assets like software/internet and technology companies. The reason behind this is, a significant portion of the assets of these companies are considered as intangible assets since these assets cannot be felt or seen. Things like brand name, goodwill, patents and so on are not counted in the book value of a company. This is why the share price of such companies have very little link with book value.

Companies that have too much liability cannot be measured properly by considering book value. Since the book value of a company refers to the difference between its tangible assets and liabilities, it can turn out to be significantly low (sometimes even negative) when a company has too much debts. A low book value will boost the P/B ratio artificially- something that is not going to give you a proper understanding about the value of a company.

One if the biggest advantages of price-to-book value ratio is that it is a simple method of valuation and if you combine the book value analysis with other valuation tools like high return on equity (ROE), you will be able to spot real bargains before the other investors does.

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