Book Value VS. Market Value: An Overview

Book Value VS. Market Value: An Overview

Valuinga listed company is a complex task, and several different measures are used toarrive at a fair valuation. While none of the methods is precise and eachpresents a different version with varying results, investors use them incombination to get a good understanding of how stocks have performed. Two mostcommonly used quantitative measures for valuing a company are market value andbook value. This article compares the two popular factors, their differences,and how they can be used in analyzing companies.

Book Value

Thebook 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 aresold and all the liabilities are paid back. This is the amount that thecompany’s creditors and investors can expect to receive if the company isliquidated.

Book Value of Equity PerShare (BVPS)

BookValue Formula
Mathematically,book value is calculated as the difference between a company's total assets andtotal liabilities.

\text{Bookvalue of a company} = \text{Total assets} - \text{Total liabilities}Book valueof a company=Total assets−Total liabilities

Forexample, if Company XYZ has total assets of $100 million and total liabilitiesof $80 million, the book value of the company is $20 million. In a broad sense,this means that if the company sold off its assets and paid down itsliabilities, the equity value or net worth of the business would be $20million.

Totalassets include all kinds of assets, such as cash and short term investments,total accounts receivable, inventories, net property, plant and equipment(PP&E), investments and advances, intangible assets like goodwill, andtangible assets. Total liabilities include items like short and long term debtobligations, accounts payable, and deferred taxes.

Book Value Example

Derivingthe book value of a company is straightforward since companies report totalassets and total liabilities on their balance sheet on a quarterly and annualbasis. Additionally, the book value is also available as shareholders' equityon 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 a bookvalue of ($258.85 billion - $176.13 billion) $82.72 billion. This is the samefigure reported as shareholder's equity.

Onemust note that if the company has a component of minority interest, that valuemust be further reduced to arrive at the correct book value. Minority interestis the ownership of less than 50 percent of a subsidiary's equity by aninvestor or a company other than the parent company. For instance, retail giantWalmart 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 networth as $80.82 billion. Additionally, the company had accumulated minorityinterest of $2.95 billion, which when reduced gives the net book value orshareholder’s equity as $77.87 billion for Walmart during the given period.

Companieswith a lot of machinery inventory and equipment, or financial instruments andassets tend to have large book values. In contrast, gaming companies,consultancies, fashion designers, or trading firms may have little to no bookvalue because they mainly rely on human capital, which is a measure of theeconomic value of an employee's skill set.

Whenbook value is divided by the number of outstanding shares, we get the bookvalue 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 itsshareholders, including share blocks held by institutional investors andrestricted shares.

Limitations of Book Value
Oneof the major issues with book value is that the figure is reported quarterly orannually. It is only after the reporting that an investor would know how thecompany’s book value has changed over the months.

Bookvalue is an accounting item and is subject to adjustments (e.g., depreciation)which may not be easy to understand and assess. If the company has beendepreciating its assets, one may need to check several years of financialstatements to understand its impact. Additionally, due to depreciation-linkedrules of accounting practices, a company may be forced to report a higher valueof its equipment though its value may have gone down.

Bookvalue may also not consider the realistic impact of claims on its assets, likethose for loans. The book valuation may be different than the real value if thecompany is a bankruptcy candidate and has several liens against its assets.

Bookvalue is not very useful for businesses relying heavily on human capital.

Market Value
Themarket 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 wouldget in the marketplace, it represents the market capitalization in the contextof companies. It is the aggregate market value of a company represented as adollar amount. Since it represents the “market” value of a company, it iscomputed based on the current market price (CMP) of its shares.

Market Value Formula

Marketvalue—also known as market cap—is calculated by multiplying a company'soutstanding shares by its current market price.
\text{Marketcap of a company} = \text{Current market price (per share)} * \text{Totalnumber of outstanding shares}Market cap of a company=Current market price (pershare)∗Totalnumber of outstanding shares

IfCompany XYZ is trading at $25 per share and has 1 million shares outstanding,then the company's market value is $25 million. Market value is most often thenumber analysts, newspapers, and investors refer to when they mention the valueof a company.

Sincethe market price of shares changes throughout the day, the market cap of acompany also changes accordingly. Changes to the number of shares outstandingare rare as that number changes only when a company pursues certain types ofcorporate actions, due to which market cap changes are primarily attributed toper share price changes.

Market Value Example
Continuingthe 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 closedat the price of $98.61 per share. The resulting market cap was (7.794 billion *$98.61) $768.56 billion. This market value is more than nine times the bookvalue of the company ($82.72 billion) calculated in the earlier section.

Similarly,Walmart had 3.01 billion shares outstanding and a closing price of $106.6 pershare as of January 31, 2018 (end of Walmart’s fiscal year). The firm's marketvalue was (3.01 billion * $106.6) $320.866 billion, which is more than fourtimes the book value of Walmart ($77.87 billion) calculated in the earliersection.

Itis quite common to see the book value and market value differ significantly.The difference is attributed to several factors, including the company'soperating model, its industrial sector, the nature of a company's assets andliabilities, and the company's specific attributes.

Market Value Limitations
Whilemarket cap represents the market perception of a company’s valuation, it maynot necessarily represent the true picture. It is common to see even mega-capand large-cap stocks moving 3 to 5 percent up or down during a day’s session. Astock often gets overbought or oversold, and relying solely on market capvaluations may not be the best method to assess a stock’s realistic potential.

Book Value and Market Value Use

Mostpublicly listed companies fulfill their capital needs through a combination ofdebt and equity. Debt is raised by taking loans from banks and other financialinstitutions or by floating interest-paying corporate bonds. Equity capital israised by listing the shares on the stock exchange through an initial publicoffering (IPO) or through other measures, such as follow-on issues, rightsissues, and additional share sales. Debt capital requires payment of interest,as well as repayment of loaned money to the creditors; however, equity capitalhas no such obligation for the company as equity investors aim for dividendincome or capital gains emerging from fluctuations in the stock prices.

Creditorswho provide the necessary capital to the business are interested in thecompany's asset value as they are more concerned about repayment. Book value isused by creditors to determine how much capital to lend to the company sinceassets are typically used as collateral or determine a company's ability to payback the loan over a given time.

Onthe other hand, investors and traders are more interested in timely buying orselling of a stock at a fair price. Market value, when used in comparison withother measures, including book value, provides a fair idea of whether the stockis fairly valued, overvalued, or undervalued.

Comparing Book and Market Value

Mostinvestors and traders use both values; there can be three different scenarioswhile comparing the book value and market value.

Bookvalue greater than market value: If a company is trading at a market valuewhich is lower than its book value, it usually indicates that the market hasmomentarily lost confidence in the company. It may be due to problems with thebusiness, loss of important business-related lawsuits, or chances of financialanomalies. In other words, the market doesn't believe that the company is worththe value on its books or that there are enough assets to generate futureprofits and cash flows. Value investors often like to seek out companies inthis category in hopes that the market perception turns out to be incorrect inthe future. In this scenario, the market is giving investors an opportunity tobuy a company for less than its stated net worth, meaning the stock price islower than the company's book value. However, there is no guarantee that theprice will rise in the future.

A market valuegreater than book value:
When the market value exceeds the book value, thestock market is assigning a higher value to the company due to the potential ofit and its assets' earnings power. It indicates that investors believe thecompany has excellent future prospects for growth, expansion, and increasedprofits that will eventually raise the book value of the company. They may alsobelieve the value of the company is higher than what the current book valuecalculation shows.

Consistently, profitable companies typically have marketvalues greater than book values, and most of the companies in the top indexesmeet this criterion, as seen from the examples of Microsoft and Walmartmentioned above. Growth investors may find such companies promising. However,it may also indicate overvalued or overbought stocks trading at a high price.

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Dr. Chao Yuang Shiang (PH.D in management), Assistant professor,Dep.of Finance,Nanhua University,Taiwan.
website:amazon.com/author/drchao

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