Intrinsic Value Vs. Market Value: An Overview
If a stock has a significantly lower intrinsic value than its current market price, it looks like a red flag that the stock is overvalued. But that's not necessarily the case.
The disparity between intrinsic value and market price is known in the investment world as the price to book ratio (P/B):
- Price is the current value of the stock as set by the market.
- Book value is the stock's intrinsic value. It is the amount a shareholder would be entitled to receive, in theory, if the company was liquidated.
The market price of any stock is almost never the same as its book value.
Market value is determined by supply and demand. The price of a stock reflects the current demand for it. If there is a strong demand from investors for a particular stock, its market price will rise above its book value.
- Market value is the current price of a company's stock.
- Intrinsic value is the sum of all of the company's assets minus its liabilities.
- The price-to-book ratio (P/B) is just one factor to look at in deciding whether a stock is overvalued or undervalued.
Although a stock may appear to be overvalued, at least temporarily, that does not mean that it should not be purchased or at least considered. Over-valuation and under-valuation are everyday occurrences.
The goal for any investor is to buy low and sell high. If an investor believes that a stock can very likely be sold in the future for a higher price than its current market price, it may well be an excellent investment, regardless of the company's current intrinsic value.
Intrinsic value, or book value, is a company's total assets minus its total liabilities.
That seems like a fairly straightforward calculation. A company may own a headquarters building, a theme park, or a casino. It probably has borrowed a certain amount of money.
Intrinsic value is not an entirely reliable number or, for that matter, a stable one.
But what are its patents or its copyrights worth, for example? Or its intangible assets like goodwill or brand recognition?
Traders are mindful that book value is not a completely reliable number or, for that matter, a stable one. One hot scandal can destroy a lot of goodwill or brand recognition. The value of a company's physical assets can change with the economy, with consumer tastes, or with time.
The P/B ratio is just one measure of equity valuation. Analysts commonly examine a company and its stock price from several angles in an effort to get the most accurate assessment of its genuine value.
A good complementary evaluation measure to a P/B comparison is the return on equity (ROE) ratio. This is an indication of how efficiently a company is using its shareholders' equity to generate additional profits.