• A company’s book value is the amount of money shareholders would be paid if a company was liquidated, after all liabilities were satisfied.
• It is important to note that book value fails to take into consideration certain intangible assets of value within a company.
• Ultimately, book value should be considered alongside a company’s debt-to-equity ratio, price-to-book ratio, price/earnings-to- growth ratio, and free cash flow before investing.
A company’s book value is determined by subtracting the total amount of its liabilities from the total amount of its assets, as represented on its balance sheet. In other words, it’s the company’s equity value — the amount of money shareholders would be paid if the company was liquidated and all of its liabilities satisfied. Seasoned investors will consider this metric in relation to a company’s market cap and several other factors to get an idea of the overall performance of the company.
So, what does book value mean?
Given that book value is based on hard numbers backed by empirical evidence, it’s often looked upon as a fair and accurate definition of the worth of a company. It is also an objective figure. After all, a company’s book value is determined based upon analysis of quantifiable company data. This stands in contrast to a firm’s market cap, which, to a degree, is reflective of investor sentiment as well as actual performance.
With these thoughts in mind, investors pursuing a value investing strategy use book value to find stocks that may be underpriced. Stocks trading below book value are typically looked upon as bargains because the likelihood of share price advances is higher with them than with stocks whose share prices and book values are at parity, or when share prices exceed book values. Stocks whose book values exceed their market caps can often help investors realize gains, as well as favorable long-term trading positions.
Assets figuring into the calculation of book value include:
Liabilities figuring into the calculation of book value include:
Thus, a company with assets of $200 million and liabilities of $120 million would have a book value of $80 million. Book value can also be expressed per share, which is determined by dividing the resulting book value by the number of outstanding shares of common stock. In this instance, our company with a book value of $80 million would have a book value per share of $8 if it had 10 million shares outstanding.
Another useful metric relating to book value is the price-to-book ratio (P/B). This is calculated by dividing the market price per share by the book value per share. Going back to our example above, that $8 per share book value would net a P/B of 10 if the market per share of the stock is $80.
Generally, a company with P/B ratio of less than one can be looked upon as a good value, as its shares are valued below that of its assets. Worst-case scenario, that company could be liquidated, and investors wouldn’t experience a loss.
As touched upon above, book values and market caps can differ because intangibles such as patents, brand value, goodwill and intellectual properties capable of affecting market caps are not considered when calculating book value. Nor does book value consider the skills of a company’s workforce.
As an example, notable tech companies often possess market caps exceeding their book values. Investors tend to perceive their intellectual properties and potential for growth as being of significant value.
However, this can sometimes backfire.
Looking back to the dot-com bubble of the late 1990s, most tech companies enjoyed market caps far exceeding their book values. Investors believed any company with a reasonable chance of succeeding in the then-nascent internet marketplace would eventually produce outsized profits.
However, when the market correction eventually came, the dot-com crash ensued.
Still, the concept holds true to this day.
Equities perceived by investors as having a strong chance of growth in value often carry share prices exceeding the book values of the companies behind them. The takeaway for investors is to look beyond the market cap to see what the book value says about the company. Further, investigate carefully to ensure that the company really does have a good chance of realizing its potential.
Private Market Investing 101, with Kal Penn
Relying solely upon book value as a bellwether of future growth potential is fraught with peril. For one thing, predicting the time horizon of an investment of that nature is difficult at best — impossible at worst. Thus, investing in a company with a favorable book value and waiting years for its share value to catch up could result in losses due to opportunity cost. A lower risk bond may well have delivered a similar yield in less time.
However, one thing book value can do is provide some insight into how a company is being managed. A management team that plows earnings back into facilities and equipment, rather than paying dividends, is likely anticipating significant growth. Further, an investment of that nature holds the potential to significantly increase the value of the company over the long term. Conversely, a company with older equipment that is delaying capital improvements could be poorly run, which, in turn, can mean little to no growth over the long term.
Ultimately though, book value should be but one of several metrics employed to inform an investing decision. While there has yet to be devised an ideal method of analyzing a stock, value investors would do well to consider factors such as the company’s debt-to equity ratio, price-to-book ratio, price/earnings-to-growth ratio, and free cash flow. Taken together, these indicators can give a value-oriented investor a more reliable indication of the true performance potential of a company.
With that said, it is also important to ensure that a portfolio is diversified enough to minimize risks, without sacrificing anticipated returns. This is the key to developing a value investing portfolio capable of producing sizable gains over the long term.
Varying the mix of asset classes held within a portfolio can help mitigate risk for investors. In many cases, fixed-price assets such as bonds, certificates of deposit and treasury notes can respond to market volatility more favorably than publicly traded equities.
Alternative investments can also be useful tools for portfolio diversification. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, and collectibles are among asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification.
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While book value can be a useful tool when it comes to preliminary determinations of a company’s value — and how favorably its stock is valued — several other fundamental indicators are not represented in book value. Metrics such as debt-to equity ratio, price-to-book ratio, price/earnings-to-growth ratio and free cash flow should also be considered.
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