When you seek a business to invest in, there are two essential concepts you should necessarily interpret: market value and book value. They are crucial in the sense that they help you evaluate an investment properly. Whether it is worthwhile to invest or it does not depend on your conclusions.
So, what do these fundamentals actually mean?
This metric is sometimes referred to as an accounting value, because it can be found on the balance sheet. Book value is computed by subtracting the company’s total liabilities from its total assets. Let’s take an imaginary Company X that owes $70 million in debt and has total assets of $100 million. The book value of Company X will be $30 million ($100 million – $70 million). Judging by the calculation method, we conclude that book value is obtained the same way as net asset value.
Let’s move on to market value, the company’s worth as stated in the stock market. To compute market value, multiply the number of a company’s shares outstanding (all the issued shares) by the current share price. Let's get back to our Company X. It has issued 10,000 shares priced at $30 each, thus the market value of Company X makes $300,000 (10,000 x $30). Logic suggests that if someone wants to own the business, they have to pay exactly the amount of the market value.
In fact, the two fundamentals hardly ever equal each other in the real financial market. There are multiple reasons for it and they differ from the individual characteristics of a company to the attributes of the whole industry.
Generally speaking, there are three possible relation patterns:
Book value exceeds market value. It happens when the market is pessimistic (bearish, in financial terms) about the ability of a company to make profits. Thus, the market puts less value on the assets as compared to the company’s book value.
Market value exceeds book value. When the market is optimistic (bullish, in financial terms) about a company, they are willing to pay more to own its assets. A business that can generate good earnings will have the fair value greater than book value.
Book value equals market value. This situation happens when the market assigns neither higher nor lower worth to a particular company as compared to the value expressed on the balance sheet.
This important metric is calculated the following way:
share market price
_____________________ = P/B ratio
book value per share
(Note: book value per share is computed dividing equity by the number of shares outstanding)
If P/B ratio:
- is less than 1, market value is less than book value
- is more than 1, market value exceeds book value
- equals 1, market value equals book value
What does P/B ratio tell? The P/B tool can be handy for value investors who look for price discrepancies. Sometimes the market may be wrong in evaluating a stock. Proponents of value investing take advantage of such an underestimation. They buy assets when the market prices are low and earn when the true worth of a company comes out.
For potential investors, it is useful to know what market and book values are all about. A particular relation between them, as well as standalone metrics, can be useful parameters to evaluate a company and decide on investing.