Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.
Understanding Book Value
Businesses that are able to generate a high return on equity with little capital expenditure will rarely ever be trading close to book value. That makes sense when you consider that the market will pay up for businesses that can churn out tons of cash. Examples include companies like Coca-Cola (NYSE:KO), Microsoft (Nasdaq:MSFT) and MasterCard (NYSE:MA). At Coke, for example, net margin and return on equity are 18 and 25%, respectively. Coke has been churning out those margins for years. Therefore, book value is a relatively meaningless valuation metric for companies like Coke, as its P/B ratio of five is not indicative of whether Coke shares are cheap or expensive.
SEE: Investment Valuation Ratios: Introduction
However, with various other businesses, book value is meaningful. The financial sector is a prime example. While the past few years have made many investors question the validity of book value at banks, it is a useful metric. The vast majority of a bank's assets are currency denominated assets and a dollar is equal to a dollar. Of course, when a sound bank makes high quality loans and other forms of credit that generate a profit, then that bank should trade equal to or above book value. Wells Fargo (NYSE:WFC) is an excellent example today. WFC has emerged from the financial crisis as the strongest and most profitable bank among its peers. As such, the market bestows a 25% premium to book value.
SEE: 10 Ways To Prepare For A Personal Financial Crisis
Thanks to a bad trade, shares in JP Morgan (NYSE:JPM) now trade for approximately 72% of book value. Before the trading loss, JPM was often grouped with Wells Fargo as one of the strongest, best-managed banks. If this trading loss turns out to be an isolated event that wasn't promoted by careless senior management, then JPM shares could be an attractive purchase at such a discount to book.
The Bottom Line
Like any investment metric, understanding a company's book value will have its advantages as well as its limitations. It is integral to use this metric wisely, and understand that for certain sectors, a company's book value and stock price are measured differently. This will assist you in effectively making sound investment decisions.
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
At the time of writing, Sham Gad did not own shares in any of the companies mentioned in this article.