In the food chain of corporate security investors, equity investors do not have the first opportunity at operating profits. Common shareholders get whatever is left over after the corporation pays its creditors, preferred shareholders and the tax man. But in the world of investing, being last in line can often be the best place to be, and the common shareholder's lot can be the biggest piece of the profit pie. Read on to discover how to get your pie and eat it too.

While corporate debt holders and preferred shareholders are entitled to a fixed series of cash payments, the cash flow in excess of those amounts is essentially the property of the common shareholders. In theory, if the common shareholders decide by majority vote to close down the corporation, they would be entitled to everything left over after they settled the claims of the debt holders and preferred stockholders. The value of a common stock, therefore, is related to the monetary value of the common shareholders' residual claim on the corporation - the net asset value or common equity of the corporation. (To find out more about shareholder issues, see Knowing Your Rights As A Shareholder and A Primer On Preferred Stocks.)

Measuring the Value of a Claim
A good measure of the value of a stockholder's residual claim at any given point in time is the book value of equity per share (BVPS). Book value is the accounting value of the company's assets less all claims senior to common equity (such as the company's liabilities).

In simplified terms, it's also the original value of the common stock issued plus retained earnings, minus dividends and stock buybacks. BVPS is the book value of the company divided by the corporation's issued and outstanding common shares. (To keep reading on book value, see Value By The Book.)

Equity investors often compare BVPS to the market price of the stock in the form of the market price/BVPS ratio to attribute a measure of relative value to the shares. Keep in mind that book value and BVPS do not consider the future prospects of the firm - they are only snapshots of the common equity claim at any given point of time. A going concern company should always trade at a price/BVPS ratio in excess of 1x if the market properly reflects the future prospects of the corporation and the upside potential of the stock.

Why BVPS?
So why use BVPS as an analytical tool if it doesn't fully measure the potential of the stock? There are a few good reasons:

1. BVPS is a good baseline value for a stock. While it's not technically the same thing as the liquidation value of the shares, it is a proxy for it. In many cases, stocks can and do trade at or below book value. If the company's balance sheet is not upside-down and its business is not broken, a low price/BVPS ratio can be a good indicator of undervaluation. (To find out more about reading balance sheets, see Reading The Balance Sheet, Breaking Down The Balance Sheet and Testing Balance Sheet Strength.)
   
   
2. BVPS is quick and easy to calculate. It can and should be used as a supplement to other valuation approaches such as the price-to–earnings (P/E) approach or discounted cash flow approaches. Like other multiple-based approaches, the trend in price/BVPS can be assessed over time or compared to multiples of similar companies to assess relative value.
   
   
3. If the company is going through a period of cyclical losses, it may not have positive trailing earnings or operating cash flows. Therefore, an alternative to the P/E approach may be used to assess the current value of the stock. This is especially applicable when the analyst has low visibility of the company's future earnings prospects.

How to Calculate BVPS
The quickest way to calculate BVPS is to look at the equity section (on the bottom right) of a company's balance sheet and think about what the common shareholder actually owns - common stock outstanding and retained earnings. The good news is that the number is clearly stated and usually does not need to be adjusted for analytical purposes. As long as the accountants have done a good job (and the company's executives aren't crooked) we can use the common equity measure for our analytical purposes. (For more insight, check out Reading The Balance Sheet.)

For example, Wal-Mart's January 31, 2006 balance sheet indicates that shareholder's equity has an accounting value of $53.2 billion. The number is clearly stated as a subtotal in the equity section of the balance sheet. To calculate BVPS, you need to find the number of shares outstanding, which is also usually stated parenthetically next to the common stock label (if it's not there you should be able to find it in a note to the financial statements). What we're looking for is the number of shares outstanding, not simply issued. The two numbers can be different, usually because the issuer has been buying back its own stock. In this case, the shares outstanding number is stated at 4.2 billion, so our BVPS number is $53.2 billion divided by 4.2 billion, which equals to $12.77. Each share of common stock has a book value - or residual claim value - of $12.77. At the time Wal Mart's 10-K for 2006 came out, the stock was trading in the $49 range, so the P/BVPS multiple at that time was around 3.8x.

Making Calculations Practical
Now it's time to use the calculation for something. The first thing one might do is compare the price/BVPS number to the historic trend. In this case, the company's price/BVPS multiple seems to have been sliding for several years. A good analyst would want to know why. A sliding price/BVPS multiple may not indicate better relative value. Secondly, one will want to compare Wal Mart's price/BVPS to similar companies. In this case, the stock seems to trade at a multiple that is roughly in line with its peers. A premium may be warranted here because of Wal Mart's massive size.



An even better approach is to assess a company's tangible book value per share (TBVPS). Tangible book value is the same thing as book value except it excludes the value of intangible assets. Intangible assets, like goodwill, are assets that you can't see or touch. Intangible assets have value, just not in the same way that tangible assets do in the sense that you cannot easily liquidate them. By calculating tangible book value we might get a step closer to the baseline value of the company. It's also a useful measure to compare a company with a lot of goodwill on the balance sheet to one without goodwill.

To calculate tangible book value, we must subtract the balance sheet value of intangibles from common equity and then divide the result by shares outstanding. To continue with the Wal Mart example, the value of goodwill on the balance sheet is $12.2 billion (we are assuming the only intangible asset material to this analysis is goodwill). The TBVPS works out to $9.76. The price/TBVPS ratio is around 5x when Wal Mart's 2006 10-K is released. Again, we would want to examine the trend in the ratio over time and compare it to similar companies to assess relative value.

Conclusion
Using book value is one way to help establish an opinion on common stock value. Like other approaches, book value examines the equity holders' portion of the profit pie. Unlike earnings or cash flow approaches, which are directly related to profitability, the book value method measures the value of the stockholders' claim at a given point in time. An equity investor can deepen an investment thesis by adding the book value approach to his or her analytical toolbox.

by Bryn Harman (Contact Author | Biography)

Bryn Harman, CFA, is a seasoned investment professional with more than 13 years of experience in the fields of corporate finance and investment finance. For the past seven years, his focus has been on bottom-up fundamental analysis of small cap companies. Harman is currently the director of research for a value-oriented investment firm in the Northwest. Bryn has a Bachelor of Commerce from the University of Saskatchewan, Canada.