What's the Meaning of Book Value?
Just as it's helpful for an individual to know their net worth, book value can tell investors and analysts how much money the company is physically worth, regardless of the stock price. Book value includes:
● Assets. Common assets include any equipment, inventory, supplies, buildings, land, cash, etc. It's important to note that these assets must be tangible assets. Intangible assets such as brand recognition, goodwill, talent, etc. do not count.
● Liabilities. Common liabilities include any debts or expenses that must be paid to others.
Book value is important because it can reveal the inner workings of a company. For example, if a business has a problem with cash flow, then it could borrow some money to overcome its financial challenges. However, this would reduce its net worth and lower its book value. Someone who compares the current book value against the same metric from a few years ago might notice this phenomenon and want to take a closer look at this trend before investing.
Why Is It Called Book Value?
The term "book value" is a reference to the practice of accounting. As they often say, when an asset is purchased or the company borrows money, these transactions must be "put on the books". This information will be used to create the company’s balance sheet which is ultimately how book value gets calculated.
Book Value per Share
The BVPS or book value per share is a helpful way to express how much of the company each shareholder is entitled to.
The equation is as follows:
BVPS = (Assets - Liabilities) / Total shares outstanding
Example
Suppose you own a company that has $3 million in assets and $2 million in liabilities. You decide to sell 100,000 shares to the public.
In this case, your BVPS would be:
[$3,000,000 - $2,000,000] / 100,000 = $10
Price-to-Book Ratio
While book value is helpful to know, by itself it doesn't necessarily tell the investor if the stock is trading at a good price. To make this comparison, investors will take the ratio of the share price against its book value to get what's known as the PB ratio or price-to-book ratio.
The equation for the price-to-book ratio is as follows:
PB Ratio = Price per Share / Book Value per Share
While you can calculate the PB ratio yourself, this metric is readily updated and available on any major financial media outlet such as Yahoo Finance or Google Finance.
What Does the PB Ratio Tell Us?
The significance of the PB ratio is that it gives investors an indication of how much more expensive a stock might be relative to its intrinsic value. For instance, a stock that has a PB ratio of 2 could be thought of as currently trading at 2 times the price of its book value.
When PB Ratio is Greater Than 1
It's fairly common for companies to trade at prices greater than their book value. This is usually because investors are more interested in the growth of the business and its ability to produce earnings. Therefore, they don't mind paying a premium for a stake of ownership.
However, this must be done with caution. If a stock trades at a multiple that is much higher than the average for its industry, then this may be a hint that the stock is currently overvalued. Hence, investors may want to wait until the price decreases to a more reasonable level.
When PB Ratio is Less Than 1
If the PB ratio is close to or less than one, then this could be interpreted in two ways.
The first is that the company is undervalued. The goal of a value investor is to profit off of businesses that are performing well but have low stock prices. A low PB ratio together with other metrics could be one way to come to this conclusion.
Another interpretation is that the company is seen as undesirable by the market. Despite having assets, the business may be experiencing negative press or dealing with changing trends that have swayed customer demand for its products. Depending on the circumstances, this may be a situation where sales have slumped and the future of the company is being called into question.
When PB Ratio is Negative
If the PB ratio is negative, this means that the company is basically insolvent - it owes more money than the value of the assets it holds. This creates a situation where the book value is negative and leads to a negative figure for the PB ratio.
Generally speaking, most investors will stay away from companies with a negative PB ratio because it means they have no profits. This can be a major red flag that the company is heading toward bankruptcy.
Limitations of Book Value
While book value can be a helpful metric, there is a lot of information that it leaves out.
For starters, book value does not represent market value. Just because a company raised $1 million from investors and spent this money on acquiring major assets such as equipment, a factory, inventory, etc. does not mean that this is what it’s worth. Market value will be determined by how much the company earns and investor demand for the stock.
Another drawback is that book value does not consider a company’s intangible assets. These can be things like patents, trademarks, etc. In certain situations, these items can be the most valuable things the company holds.
Finally, it's important to remember that book value is based on historical costs. Since the market price of assets changes over time, the value of these transactions may not hold over time.
The Bottom Line
If a company was to be liquidated by selling all of its assets and paying off each of its liabilities, then the amount that would be leftover is its book value. Comparing the stock price against this figure is how the price-to-book ratio is calculated.
While this metric can reveal potential trading opportunities for investors, it does not give the full picture of the future prospects of the business. Investors should use book value in conjunction with other stock valuation metrics to get a full perspective on the company.