Understanding the difference between book value and market
value is a simple yet fundamentally critical component of any attempt to
analyze a company for investment. After all, when you invest in a share of
stock or an entire business, you want to know you are paying a sensible price. Both book value and
market value can be important tools for investors hoping to build strong
portfolios. While the market price of each stock provides clues to a company's
financial strength and future prospects, book value reveals the current state
of the company and ignores future growth potential. Combining these two figures
can help you determine whether a stock is valued correctly, which can help you
get the most out of your investment.
Book
Value literally
means the value of the business according to its "books" or financial
statements. In this case, book value is calculated from the balance sheet,
and it is the difference between a company's total assets and total
liabilities. Note that this is also the term for shareholders' equity. The book value of a company represents how much a
company is worth based strictly on its balance sheet. To find book value, add
up everything the company owns in terms of assets, then subtract everything the
company owes, such as debts and other liabilities. Book value reveals how much
the company is worth if it were liquidated and all assets were sold for cash.
By dividing book value by the total number of shares outstanding, you can find
book value per share.
Market
Value is
the value of a company according to the stock market. Market value is
calculated by multiplying a company's shares outstanding by its
current market price. Market value per share is a much easier figure to
derive. The market value per share is simply the price of each share on the
open market or how much it would cost to buy a share of stock at any given
point. While book value represents how much the company's assets are worth,
market value reveals what investors think the company is worth and how much
they will pay to buy stock in the firm.
Implications
of Each
Book
value simply implies the value of the company on its books, often referred to
as accounting value. It's the accounting value once assets and liabilities have
been accounted for by a company's auditors. Whether book value is an accurate
assessment of a company's value is determined by stock market investors who buy
and sell the stock. Market value has a more meaningful implication in the sense
that it is the price you have to pay to own a part of the business regardless
of what book value is stated:
- Book
Value Greater Than Market Value: The
financial market values the company for less than its stated value or net
worth. When this is the case, it's usually because the market has lost
confidence in the ability of the company's assets to generate future
profits and cash flows.
In other words, the market doesn't believe that the company is worth the
value on its books. Value investors often
like to seek out companies in this category in hopes that the market
perception turns out to be incorrect. After all, the market is giving you
the opportunity to buy a business for less than its stated net worth.
- Market
Value Greater Than Book Value: The market assigns a higher value to the company due to
the earnings power of the company's assets. Nearly all consistently
profitable companies will have market values greater than book values.
- Book
Value Equals Market Value: The
market sees no compelling reason to believe the company's assets are
better or worse than what is stated on the balance sheet.
It's
important to note that on any given day, a company's market value will
fluctuate in relation to book value. The metric that tells this is known as the
price-to-book ratio, or the P/B ratio:
P/B Ratio
= Share Price/Book Value Per Share
(where
Book Value Per Share equals shareholders' equity divided by number of shares
outstanding)
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