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Definition of Book Value and Examples

Book value is a term that describes the basic net value of a company. It is the total of its assets minus its liabilities. You can use it to assess the value of the company relative to its outstanding shares and stock price. It is important to evaluate book value alongside other metrics before deciding whether stocks are a good choice for your financial investment.

How to Use Book Value When Investing

Book value alone does not give you much data about the true value and potential returns of the company. For example, just because one company has a net value of one million dollars and another has a net value of two million dollars, it does not mean that the second one is always the better place to put your investment money. For this reason, people who use it often look at book value and how it relates to other metrics to compare different stocks.

One way to compare companies is to convert it to book value per share, which is simply the book value divided by the number of outstanding shares. Let’s build on the previous example:

The first company has a book value of one million dollars and has 100,000 shares outstanding. The book value per share is 10 dollars.

The second company is valued at 2 million dollars and has 10,000 shares outstanding. The book value per share is 200 dollars.

Another common practice used by people is to compare the price-to-book ratio between companies. This ratio compares the company’s stock price to the book value per share. Let’s build on the previous example:

The first company has a book value per share of 10 dollars and a market price per share of 50 dollars. The price-to-book ratio is 5.0. Investors are likely to see this stock as being valued above its true worth.

The second company has a book value per share of 200 dollars and a market price per share of 100 dollars. The price-to-book ratio is 0.5. Investors are likely to see this stock as being valued below its true worth.

It can be noted that the first company seemed like the better option initially, but a deeper look raised some red flags.

Note: Smart investors should be thorough in evaluating stocks from multiple angles instead of buying based on just one value indicator.

Limitations of Book Value

Another factor in looking at book value is that it does not account for intangible assets, such as patents, copyrights, and trademarks. While these assets may not be tangiblyvalued in the company’s books, they offer a lot of value over time.

Other limitations of what book value shows is that it uses historical cost to price some assets that may have significantly appreciated over a long period of time. The mind often goes to real estate that is used and owned by the company. What’s more, book value may not provide a clear picture when a company has a large amount of capital assets and uses a reckless depreciation method. In either case, book value can be higher than just assets minus liabilities.

For these reasons, you should always consider other valuation metrics that address factors outside of book value.

Note: A company that is deemed viable and growing will always be worth more than its book value due to its ability to create earnings and growth.

Other Important Values for Investors

You wouldn’t want to engage in an investment until you can understand many aspects of the stock value. Here are some other common terms you might want to look into and ensure you understand:

–

Earns Per Share (EPS): This is the amount of the company’s profit that goes to each share of stock.

– Price to Earnings Ratio (P/E): This measures the current price of the stock against the earnings per share.

– Expected Earnings Growth (PEG): Looks at the price to earnings ratio compared to the growth rate.

– Price to Sales Ratio (P/S): The company’s market value is divided by its most recent annual revenue. The price to sales ratio can also be found by dividing the stock price by the revenue per share.

– Dividend Payout Ratio: This ratio compares the number of dividends paid to shareholders against the company’s net income.

– Dividend Yield: This is the current price of the stock, derived by dividing the company’s annual dividend by the current stock price and then multiplying by 100 to get a percentage.

– Return on Equity: Evaluates the company’s return on profit relative to the book value of each shareholder’s equity.

Note: A company that is considered sustainable and growing may not always be worth more than its book value due to its ability to generate profit and growth.

Source: https://www.thebalancemoney.com/understanding-book-value-3140780

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