How book value and ROE relate

Book value and return on equity are two very useful metrics for understanding the value and profitability of all businesses, but especially financial companies. These simple metrics are easy to calculate and can be further modified to better understand the performance of individual businesses.

In this week Industry: Finance, Gaby Lapera and Jordan Wathen of The Motley Fool discuss how investors can use financial ratios to better understand the stocks they hold in their portfolios.

A transcript follows the video.

This podcast was recorded on March 7, 2016.

Gaby Lapera: Jordan, do you want to go ahead and start talking about book value per share?

Jordan Wathen: Sure. So when you think about book value, book value is basically equity. And you get the equity by looking at the balance sheet. You look at the asset and subtract the liability from the asset to get equity. And then from there, of course, you divide the equity by the number of shares to get your book value per share.

And that’s a really valuable thing to understand. Basically, what do the shareholders of a company have, after all the liabilities, the bondholders, the people who gave you stocks, for example, on credit, once paid off, what do they have left to the shareholders? And so, understanding that value per share can really help you understand the value behind an individual stock that you might own. So if you own 100 stocks and you can know the book value per share, you basically know the net value of those stocks for accounting purposes.

Lapera: I have a question for you. What about the intangible book value?

Wait : Intangible book value, in particular – this is a financial issue, so with the banks, it is a significant issue. Intangible book value, especially for banks, generally corresponds to goodwill. It is therefore the value that exceeds the tangible value of the assets of an acquisition. So, if a bank buys another bank, it will not only pay 1x equity. They will typically pay something like 1.5 times equity, and the additional 0.5 times equity must be applied to an asset after an acquisition. And usually that’s attributed to goodwill, which is basically the value of customer relationships, the value of the brand, things that couldn’t necessarily be sold, if you had to sell them.

Lapera: Okay, it’s not a printer. It’s more of a feeling.

Wait : It’s true, it’s something that doesn’t really exist, but it does. It is difficult to explain. (Laughs)

Lapera: Yeah, absolutely. But that still factored into the book value per share, so it’s something you want to keep in mind. You could, of course, make a tangible book value per share. And tangible, of course, means things you can touch. So these are literally the assets of the business, to the exclusion of any kind of goodwill that might be reflected in the books.

Wait : To the right. When people look at banks, they usually like to look at tangible book value because that gives you a really good understanding of a bank’s actual liquidation value. Also, when you measure ROE, which we’ll get to, if you measure tangible ROE, it’s kind of like a measure of how quickly a bank could grow organically, rather than how quickly. ‘acquisitive.

Lapera: Okay. You sort of settled down there, do you mean ROE now?

Wait : So return on equity, once you calculate the book value – so you take your assets, you subtract the liabilities, now you have your book value. Return on equity is, you take the net income of the business and then you divide it by the book value. So if a company earns $ 100 million on a book value of $ 1 billion, the return on equity for that company would be 10%.

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