How they differ, how they help investors
- Book value and market value are ways of valuing a business. The book value is based on its balance sheet; market value on its share price.
- If the book value is greater than the market value, it suggests an undervalued stock. If the book value is lower, it may mean an overvalued stock.
- Book value and market value are best used in tandem when making investment decisions.
- Visit the Business Insider Investment Reference Library for more stories.
Of the many metrics that investors can value a business, two tools are particularly popular: book value and market value.
Aside from the word “value” in their names, the two men have little in common.
One is an objective approach that encompasses balance sheets and financial statements – the books of a business. The other is a more subjective approach, which takes into account the sometimes irrational feelings of the stock market.
Despite these differences, or because of them, investors often compare the book value and market value of a company to determine whether stocks are overvalued or undervalued, and therefore whether the stock is a good deal or not. .
Let’s compare the two metrics more closely.
What is book value?
Book value can be thought of primarily as the break-up value of a business – the amount the business would be worth if it went into liquidation.
Calculated from a company’s balance sheet, it takes into account all of the company’s assets – physical valuables, inventory, and investments in equipment and real estate. It then subtracts intangible assets (copyright, patents, intellectual property) and liabilities (such as loans, taxes and other debts).
Let’s say a company had total assets of $ 20 million, including $ 5 million of intangible assets. Let’s also say that a company had a liability of $ 8 million. The book value of the company would be $ 7 million: $ 20 million – $ 5 million – $ 8 million.
Book value is best used with businesses that have significant physical assets, such as manufacturers that own factories and factories, heavy machinery, and other equipment. It does not work as precisely for companies whose assets are primarily intangible assets, such as computer or digital technology companies, whose assets reside primarily in intellectual property – their formulas, systems, algorithms, etc.
Book value alone is just a reflection of a company’s equity – what it owns. To be used as a decision-making tool, it must be compared to the market value of a company before an investor can determine whether they want to buy or sell a stock.
What is the market value?
Market value is also known as market capitalization, it is the value of all the shares of a company in the market. This is what it would cost you if you were to redeem each of its outstanding shares at the current share price.
It can be calculated by multiplying the share price by the total number of shares traded.
For example, if the current stock price of ABC Company is $ 105 and the company has 80 million shares outstanding, its market value is $ 8.4 billion: 105 x 80 million.
Market value can be a volatile number. It changes throughout the day as a company’s stock price is constantly fluctuating as investors and traders buy and sell the stocks.
For the most part, however, the number does not change very drastically; this only happens if there is significant good or bad news about the company or industry in which it operates. The total number of shares outstanding hardly ever changes, only on rare occasions when the company repurchases or issues more shares.
Book value vs market value
The main differences between book value and market value include:
- What they are based on. Book value is a valuation of a business that takes concrete financial figures into consideration: real assets and liabilities. Market value is the valuation of a company based on its share price. Yes, it’s a number, but it’s a number that fluctuates based on investor perceptions of the business, including intangibles like proprietary software, artificial intelligence algorithms, and growth prospects. future. It is a way of dimensioning a company by the value that investors place on it.
- How up to date they are. One of the disadvantages of book value is that it can only be determined from a company’s financial statements. As companies typically only publish quarterly or annual financial statements, the book value is not a readily available number and therefore it is a number that can change from one reporting period to the next without any idea of ââhow. intermediate period. Market value, on the other hand, is available every day throughout the day.
- How understandable / accessible they are. Book value can be difficult to determine unless an investor tries to understand how a company’s accounting practices work: the type of depreciation used on assets, claims on assets, and how creditors could sell them into liquidation. Accounting valuation may be subject to various accounting practices and tax legislation which may make it an adjustable figure. Market value, on the other hand, is pretty transparent and easy to find – company market capitalization numbers are usually part of online stock listings and company profiles.
- How precise they are. Of course, the numbers can be manipulated and the value is to some extent in the eye of the beholder. Still, assuming everything is stated accurately, book value is an insightful number that can be an indicator of one’s financial health. But the market value of a business is based on perception and therefore is not necessarily an accurate representation of its value. A company’s stock price can be inflated or deflated for a variety of reasons, such as announcing an acquisition, new product, or trial, without any real understanding of the real impact or ramifications. of these events. The history of finance is dotted with companies and industries, like dotcom stocks in 2000, which inflate in speculative bubbles based on news and rumors, only to collapse when investors realize their market value doesn’t match. to their actual financial situation.
Compare book value and market value
You don’t have to choose between using book value and market value. The real benefit for investors lies in comparing these values ââwith each other for a specific company.
If the book value is greater than the market value, it could mean an undervalued stock. If the book value is lower, it may mean an overvalued stock.
So, if a company’s book value is greater than its market value, it means investors are ignoring its real financial fundamentals – the strength of its operations and balance sheet. This can represent a good opportunity to buy shares in a company, as its price will most likely appreciate once the market realizes the intrinsic strength of the company.
Conversely, if the market value of a business is greater than its book value, it most often indicates a business that is priced too high and the real value of which is not living up to its perceived value. This would be a good time to sell the stock or avoid buying it, as there will most likely be a market correction causing the stock price to fall.
If the market value of a business is higher than its book value but eventually begins to drop below its book value, this could indicate a loss of investor confidence in the business that has not yet been factored into. its book value.
The financial report
Book value and market value are two ways to value a business. Book value is based on a company’s balance sheet while market value is based on a company’s stock price, which often changes due to stock market sentiment.
Book value represents the financial strength of a business relative to its assets, a target number. In contrast, market value represents the attractiveness of a company’s share in the market, a somewhat more subjective number.
Investors should use book value and market value in tandem when making investment decisions. Of course, just looking at the numbers is not enough. An investor must understand the rationale behind the numbers to make an informed stock selection.