Valuing a listed company is a complex task, and several different measures are used to arrive at a fair valuation. While none of the methods is precise and each presents a different version with varying results, investors use them in combination to get a good understanding of how the stocks have been fairing. Two most commonly used quantitative measures for valuing a company are market value and book value. This article compares the two popular factors, their differences and how they can be used in analyzing companies.
Book value literally means the value of a business according to its books (accounts) that is reflected through its financial statements. Theoretically, book value represents the total amount a company is worth if all its assets are sold and all the liabilities are paid back. This is the amount that the company’s creditors and investors can expect to receive if the company goes for liquidation.
Book Value of Equity Per Share (BVPS)
Book Value Formula
Book value of a company = Total assets – Total liabilities
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.
Total assets include all kinds of assets, like cash and short term investments, total accounts receivable, inventories, net property, plant and equipment (PP&E), investments and advances, intangible assets like goodwill, and tangible assets. Total liabilities include items like short and long term debt obligations, accounts payable, and deferred taxes.
Book Value Example
Deriving book value of a company is straightforward, as companies report total assets and total liabilities on their balance sheet on a quarterly and annual basis. Additionally, the book value is also available as shareholders' equity on the balance sheet. For example, technology leader Microsoft Corp.’s (MSFT) balance sheet for the fiscal year ending June 2018 reports total assets of $258.85 billion and total liabilities of $176.13 billion. It leads to Microsoft’s book value as ($258.85 billion - $176.13 billion) = $82.72 billion. This is the same figure reported as shareholder's equity.
One must note that if the company is having a component of minority interest, that value must be further reduced to arrive at the correct book value. Minority interest is the ownership of less than 50 percent of a subsidiary's equity by an investor or a company other than the parent company. For instance, retail giant Walmart Inc. (WMT) had total assets of $204.52 billion and total liabilities of $123.7 billion for the fiscal year ending January 2018, which gives its net worth as $80.82 billion. Additionally, the company had accumulated minority interest of $2.95 billion, which when reduced gives the net book value or shareholder’s equity as $77.87 billion for Walmart during the given period.
Companies with lots of machinery inventory and equipment, or lots of financial instruments and assets, like banks, tend to have large book values. In contrast, gaming companies, consultancies, fashion designers or trading firms may have little or no book value because they mainly rely on human capital which is a measure of the economic value of an employee's skill set instead of tangible assets.
When book value is divided by the number of outstanding shares, we get the book value per share (BVPS) which can be used to make a per share comparison. Outstanding shares refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares.
Limitations of Book Value
One of the major issues with book value is that the figure is reported at a quarterly or annual frequency. It is only after the reporting that an investor would know how the company’s book value has changed over the months.
Book value is an accounting item, and is subject to adjustments like depreciation which may not be easy to understand and assess. If the company has been depreciating its assets, one may need to check several years of financial statements to understand its impact. Additionally, due to depreciation-linked rules of accounting practices, a company may be forced to report higher value of its equipment though its value may have gone down way too much.
Book value may also not consider the realistic impact of claims on its assets, like those for loans taken. The book valuation may be way different than the real value if the company is a bankruptcy candidate and has several loans against its assets.
Book value is not very useful for businesses relying heavily on human capital.
Market value represents the value of a company according to the stock market. While market value is a generic term that represents the price an asset would get in the marketplace, in the context of companies it represents the market capitalization. It is the aggregate market value of a company represented in dollar amount. Since it represents the “market” value of a company, it is computed based on the current market price (CMP) of its shares.
Market Value Formula
Market value or market cap is calculated by multiplying a company's outstanding shares by its current market price.
Market Cap of a Company = Current Market Price (per share) * Total Number of Outstanding Shares
If Company XYZ is trading at $25 per share and has 1 million shares outstanding, then its market value is $25 million. Market value is most often the number analysts, newspapers and investors refer to when they mention the value of a company.
Since market price of shares keeps changing every second, the market cap of a company also changes accordingly. Changes to the number of shares outstanding are rare as that number changes only when a company goes for certain types of corporate actions, due to which market cap changes are primarily attributed to per share price changes.
Market Cap Example
Continuing the above mentioned examples, the shares outstanding for Microsoft on June 29, 2018 (end of Microsoft’s fiscal year) were 7.794 billion and the stock closed at the price of $98.61 per share. The marketcap of Microsoft comes to (7.794 billion * $98.61) = $768.56 billion. This market value is more than nine times the book value of the company ($82.72 billion) calculated in the earlier section.
Similarly, Walmart had 3.01 billion shares outstanding and closing price of $106.6 per share as of January 31, 2018 (end of Walmart’s fiscal year). Its market value comes to (3.01 billion * $106.6) = $320.866 billion, which is more than four times the book value of Walmart ($77.87 billion) calculated in the earlier section.
It is quite common to see book value and market value differ significantly at the vast majority of the time. The difference is attributed to several factors which include the company's operating model, its industrial sector, the nature of a company's assets and liabilities, and the company's specific attributes.
Market Cap Limitations
While market cap represents the market perception of a company’s valuation, it still remains the overall market perception and may not necessarily represent the true picture. It is common to see even mega-cap and large-cap stock moving 3 to 5 percent up or down during a day’s session. A stock often gets overbought or oversold, and relying solely on market cap valuations may not be the best method to assess a stock’s realistic potential.
Use of Book Value and Market Value - Who Uses What?
Most publicly listed companies fulfill their capital needs through a combination of debt and equity. Debt is raised by taking loans from banks and other financial institutes, or by floating interest-paying corporate bonds. Equity capital is raised by listing the shares on the stock exchange through initial public offering (IPO), or through other measures like follow-on issues, rights issues and additional share sale. Debt capital requires payment of interest as well as repayment of loaned money to the creditors, while equity capital has no such obligation for the company as the equity investors aim for dividend income or capital gains emerging from fluctuations in the stock prices.
Creditors who provide the necessary capital to the business are interested in the company's asset value as they are more concerned about its repayment capacity. Book value is used by creditors to determine how much capital to lend to the company since assets are typically used as collateral for such loans or determine a company's ability to pay back the loan over a given timeframe.
On the other hand, investors and traders are more interested in timely buying or selling of a stock at a fair price. Market value, when used in comparison with other measures including book value, provides a fair idea of whether the stock is fairly valued, overvalued or undervalued.
Comparing Book Value and Market Value
Most investors and traders use both the values, and there can be three different scenarios while comparing the book value and market value.
- Book value greater than market value: If a company is trading at a market value which is lower than its book value, it usually indicates that the market has lost confidence in the company for the moment. It may be due to problems with the business, loss of important business related lawsuits, or chances of financial anomalies. In other words, the market doesn't believe that the company is worth the value on its books or that there are enough assets to generate future profits and cash flows. Value investors often like to seek out companies in this category in hopes that the market perception turns out to be incorrect in future. In this scenario, the market is giving investors an opportunity to buy a company for less than its stated net worth, meaning the stock price is lower than the company's book value. However, there is no guarantee that price will rise in future.
- Market value greater than book value: When the market value exceeds the book value, the stock market is assigning a higher value to the company due to the potential of the earnings power of the company and its assets. It indicates that investors believe the company has excellent future prospects for growth, expansion and increased profits that eventually raise the book value of the company. They may also believe the value of the company is higher than the current book value calculation shows. Consistently profitable companies typically have market values greater than book values and most of the companies in the top indexes meet this criterion, as can be seen from the examples of Microsoft and Walmart mentioned above. Growth investors may find such companies promising. However, it may also indicate overvalued or overbought stocks which are trading at a high price.
- 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.
A popular ratio that is used to compare market and book values is the price-to-book (P/B) ratio, which is calculated as per share price divided by book value per share. For example, a company has a P/B of 1, meaning that book value and market value are equal. The next day, the market price drops and the P/B ratio becomes less than 1, meaning market value is less than book value (undervalued). 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 (overvalued). Since price changes every second, it is possible to track and spot stocks which move from P/B ratio of less than one to more than one, and time the trades to maximize the profits.
The Bottom Line
Both book value and market value offer meaningful insights to a company's valuation, and comparing the two can help investors determine whether a stock is overvalued or undervalued given its assets, liabilities and its ability to generate income. Like with any financial metric, the real utility comes from recognizing the advantages and limitations of book value and market value. An investor must determine when the book value or market value should be used, and when it should be discounted or disregarded in favor of other meaningful parameters when analyzing a company.