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.
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. For example, if Company XYZ has total assets of $100 million and total liabilities of $80 million, the book value of the company is $20 million. In a very broad sense, this means that if the company sold off its assets and paid down its liabilities, the equity value or net worth of the business, would be $20 million.
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. If Company XYZ has 1 million shares outstanding and each share trades for $50, then the company's market value is $50 million. Market value is most often the number analysts, newspapers and investors refer to when they mention the value of the business.
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.
As you can see from our fictitious example from Company XYZ above, market value and book value differ substantially. In the actual financial markets, you will find that book value and market value differ the vast majority of the time. The difference between market value and book value can depend on various factors such as the company's industry, the nature of a company's assets and liabilities, and the company's specific attributes. There are three basic generalizations about the relationships between book value and market value:
- 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)
So one day, a company can have a P/B of 1, meaning that BV and MV are equal. The next day, the market price drops and the P/B ratio is less than 1, meaning market value is less than book value. The following day the market price zooms higher and creates a P/B ratio of greater than 1, meaning market value now exceeds book value. To an investor, whether the P/B ratio is 0.95, 1 or 1.1, the underlying stock trades at book value. In other words, P/B becomes more meaningful the greater the number differs from 1. To a value-seeking investor, a company that trades for a P/B ratio of 0.5 implies that the market value is one-half of the company's stated book value. In other words, the market is selling you each $1 of net assets (net assets = assets - liabilities) for 50 cents. Everyone likes to buy things on sale, right?
Which Value Offers More Value?
So which metric - book value or market value - is more reliable? It depends. Understanding why is made easier by looking at some well-known companies.
The Coca-Cola Co. has historically traded at a P/B ratio of 4 to 5. This means that Coca-Cola's market value has typically been 4 to 5 times larger than the stated book value as seen on the balance sheet. In other words, the market values the firm's business as being significantly worth more than the company's value on its books. You simply need to look at Coca-Cola's income statement to understand why. Coca-Cola is a very profitable company. Its net profit margin exceeds 15%. In other words, it makes at least 15 cents of profit from each dollar of sales. The takeaway is that Coca-Cola has very valuable assets - brands, distribution channels, beverages - that allow the company to make a lot of money each year. Because these assets are so valuable, the market values them far more than what they are stated as being worth from an accounting standpoint.
Another way to understand why the market may assign a higher value than stated book is to understand that book value is not necessarily an accurate value of a company's net worth. Book value is an accounting value, which is subject to many rules like depreciation that require companies to write down the value of certain assets. But if those assets are consistently generating greater profit, then the market understands that those assets are really worth more than what the accounting rules dictate. Other high-quality companies such as Johnson & Johnson (NYSE:JNJ), Pepsi (NYSE:PEP) and Procter and Gamble (NYSE:PG) will also possess market values far greater than book values.
Wells Fargo (NYSE:WFC):
Wells Fargo is one of the oldest and largest banks in the U.S. It typically trades for a P/B of 1, give or take a few percent. In other words, the market values Wells Fargo at or close to its book value. The reason here is simple, and it is explained by the industry Wells Fargo operates in. Financial companies hold assets that consist of loans, investments, cash and other financial securities. Since these assets are made of dollars, it's easy to value them: a dollar is worth a dollar. Of course we know that some financial assets can be better than others; for example, a good loan versus a bad loan. A good loan is one that is paid in full and the bank recoups 100 cents on the dollar. A bad loan can stick the bank with a loss and recoup 50 cents on the dollar. That's why whenever banks experience a financial crisis, as we saw in the subprime meltdown in 2008, their market values crash below book value. The market loses faith in the value of those assets.
On the other hand, financial institutions like American Express (NYSE:AXP), which have a long history of extending out good credit, will trade at a modest premium to book value. Banks that the market views as having made bad credit decisions will trade below book. But in general terms, you will never see banks trading for multiples of book value like you would see in Coca-Cola because of the nature of the assets.
When The Values Matter
To determine how book value relates to market value, look at the income generated by the company's assets. A company than can generate a relatively high income level from its assets will typically possess a market value that's far higher than its book value. This is called the company's return on assets, or ROA. Coca-Cola's ROA is typically around 7% to 8%. This means each dollar of Coke's assets generates 7 to 8 cents of profit. Wells Fargo has an ROA of 1% to 2%, earning 1 to 2 cents from each dollar of assets. Because Coca-Cola's assets generate more profit per dollar, its assets will be valued much higher in the marketplace. What this also means is that in the case of companies like Coca-Cola, book value is not as meaningful as it would be for a company like Wells Fargo.
The Bottom Line
Book value, like almost all other financial metrics, has its usefulness. But as is often the case with financial metrics, the real utility comes from understanding the advantages and limitations of book value. An investor must use that understanding to determine when book value should be used, and when it should be disregarded in favor of other meaningful parameters when analyzing a company.