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Among the many measures that investors can evaluate companies, two tools are especially popular: book value and market value.
Aside from the word “value” in their names, though, the pair have little in common.
One is an objective approach that encompasses balance sheets and financial statements — a company’s books. The other is a more subjective approach, which takes into account the sometimes irrational sentiments of the stock market.
Despite these differences, or because of them, investors often set a company’s book value and market value against each other to determine if the shares are overpriced or underpriced — and so whether the stock’s a good deal or not.
Let’s compare the two metrics more closely.
Book value can be seen basically as a company’s break-up value — the amount that the company would be worth if it were liquidated.
Let’s say a company had total assets of $20 million, of which $5 million were intangible assets. Let’s also say a company had liabilities 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 companies that have significant physical assets, such as manufacturers that own factories and plants, heavy machinery, and other equipment. It doesn’t work as accurately for companies whose assets are primarily intangible assets, such as info-technology or digital firms, whose assets lie 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 an decision-making tool, it needs to be compared to a company’s market value before an investor can determine whether to buy or sell a stock.
Market value is also known as market capitalization, is the value of all of a company’s stock in the marketplace. It’s what it would cost you if you were to buy up every one of its outstanding shares at the current share price.
It can be calculated by multiplying the share price by the total number of shares that are trading.
For example, if the current stock price of Company ABC 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 figure. It changes throughout the day because a company’s share price constantly fluctuates, as investors and traders buy and sell the stock.
For the most part, though, the number doesn’t change very drastically; it only happens if there is significant good news or bad news related to the company or to the industry in which it operates. Total shares outstanding almost never changes, only on rare occasions when company’s enact stock buybacks or issue more shares of stock.
The key differences between book value and market value include:
You don’t have to choose between using book value and market value. The real advantage for investors lies in comparing these values to one another for a specific company.
If book value is higher than market value, it can mean an undervalued stock. If the book value is lower, it can mean an overvalued stock.
So if the book value of a company is higher than its market value, it means that investors are not factoring in its actual financial fundamentals — the strength of its operations and balance sheet. It can mean a good opportunity to purchase a company’s stock as its share price will most likely appreciate, once the market realizes the company’s intrinsic strength.
Conversely, if a company’s market value is higher than its book value, it most often indicates a company that is overpriced, and whose actual worth does not live up to its perceived worth. This would be a good time to sell the stock or avoid buying it as most likely there will be a market correction, causing the share price to drop.
If a company’s market value is above its book value but starts to fall to eventually below its book value, it could indicate a loss of investor confidence in the company that has not yet been factored into its book value.
Book value and market value are two ways to value a company. Book value is based on a company’s balance sheet while market value is based on a company’s share price, which changes often due to stock market sentiment.
Book value represents the financial strength of a company based on its assets, an objective number. In contrast, market value represents the attractiveness of a company’s share in the marketplace, 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 figures isn’t enough. An investor needs to understand the rationale behind the numbers to make an educated stock pick.