Book Value, P/B Ratio & Market Value – What Are These?
Analysts use various methods to determine the value of a listed company. Such valuations are also important for retail and other investors to determine fair value of a company. One of these methods is the book valuation method. It is a widely used accounting method to determine the true standing of a company when it comes to its financial position. Let’s learn more about it in detail.
What is Book Value?
Book value, in simple words, is the difference between the value of a company’s total assets and its intangible assets plus total liabilities. This metric is used by analysts to ascertain the fair value of a company. It is also the net asset value of a company.
The formula to calculate the book value is as follows:
|Book Value = Total Assets – (Intangible Assets + Total Liabilities)|
What is Book Value Per Share?
The metric of book value per share, also known as BVPS, is a common method used by investors to determine book value of every outstanding share of the company. The resultant figure is the value that shareholders will receive per share in case of liquidation. To arrive at book value per share, you need to divide the book value or the shareholder’s equity by the number of outstanding shares.
Therefore, BVPS is:
|BVPS = (Book Value- Preference Share Value)/ Total outstanding shares|
Remember that while calculating book value per share, value of preference shares is not included. It is because preference shares are repaid before common shareholders. Therefore, to find out the value receivable to common shareholders, there is no inclusion of preference shareholders.
What is Price to Book Value Ratio?
Price to book value ratio is a comparison between the market value of a company and its book value. It is calculated by dividing the market capitalisation of a company by its book value. Market capitalisation is the product between all the outstanding shares of a company and the price at which they are being traded.
|P/B Ratio = Market Capitalisation/Book Value|
A P/B Ratio over 1 indicates that shares of a company are trading above the book value of the company. Whereas the ratio below one indicates that the shares are undervalued. Such shares can be considered for investment purposes because they indicate scope for further growth. This obviously depends on multiple other factors as well.
Significance of Book Value Method
Book value method is used to ascertain the value of shareholder’s equity in a company. They are part owners of a company and it is with their funds that a company grows further. Now if a potential shareholder wants to find out if the company is worth their money, they can use the book value method to ascertain the same.
When a company goes into liquidation, common shareholders are the last ones to get paid after all other liabilities are settled. With this valuation method, one can calculate the final value that shareholders of a company can expect to recover if the company goes into liquidation at a given time.
Disadvantages of Using Book Value Method
Even though the book value method is a fair indication of the financial health of a company, there are several aspects where it fails. Some areas where it may not provide an accurate analysis include:
- Ignorance of the market phenomenon: The market is an ever-changing place. A land that was bought ten years ago for ₹20 lakh would not fetch ₹20 lakh in the present. Based on several aspects, its value would have changed over time. It would likely have appreciated manifolds in ten years. However, if you look at the value of that land in the company’s books, after charging for depreciation, it would have come down by several lakhs below ₹20 lakh.
So as per books, it might be valued at, let’s say ₹15 lakh. In this case, if an investor analysed the book value of the company’s reports, the value he would get would not be realistic in this scenario.
- Overlooked Intangible Assets: The intangible assets of a company, such as intellectual property, brand value, and goodwill, are not taken into consideration by book value. Although they are not included in a company’s book value, these assets may be important to its operations and future growth. Because of this, book value may not be a thorough indicator of a company’s underlying value.
- Gaps in Data Publishing: A company releases its financial statements quarterly and annually. But the changes in the data take place every day which is not available to the public. This period, during which the potential investors and shareholders remain in the dark, results in making investment decisions based on old data.
Book Value vs Market Value
Book value is derived from the value that a company records in its books. It only tells the cost a company would incur if it is liquidated. However, market value is derived from the number of outstanding shares of the company and the price at which they are being traded in the market at present. Market recognises the value of intangible assets, human resources, goodwill as well as any other factor that can affect the value of that company.
Real-time events and fluctuations affect the stock market accordingly. This is the reason why market value is also often higher than the book value. Both methods have their limitations and if used standalone, neither of them can give you the exact picture. Therefore, it is important to look at other facts and figures as well to interpret the data better.
Book Value or Market Value – Which One is a Better Analysis Factor?
Both book value method and market valuation method have their shortcomings.
The book value method does not consider the intangible assets of a company; on the other hand, a market valuation might not represent the real picture either. The market fluctuates for several reasons and sometimes the value might not even be related to the performance of the company.
Either method has its own relevance and depending on your view of the market and investment strategies, you can pick the more suitable one.
Book value metric is a primary method for interpreting the worthiness of a company. However, it is always wise to take the market factors and other aspects into consideration before arriving at a conclusion. This is because, like all other metrics, the book value method also lags in some aspects and may not portray an accurate image.
Frequently Asked Questions
Why should a shareholder know about the book value of a company?
hareholders are part owners of a company. It is their funds that a company uses to expand further. So if a company goes into liquidation, shareholders are paid after all other liabilities have been settled.
So as a shareholder, it is crucial to know how much return you can expect on your investments. Even if the company does not go into liquidation, it would still help you understand the value of a company and its growth potential.
Is book value an absolute indicator of a company’s financial position?
Book value is strictly related to the financial books of a company. It does not consider several other relevant factors which can affect the real financial standing of the company. Therefore, book value is not an absolute indicator of the financial position of a company.
What is the limitation of book value in relation to intangible assets?
Intangible assets are not considered while calculating the book value of a company. So for companies where a majority of their assets are intangible like intellectual properties, goodwill, human resources, etc., book value method would not be a very accurate method to find out its true standing.
Can I use book value to calculate the value of an asset?
Yes, you can use the book value method to find out the value of an asset. To calculate it, take the total value of an asset and from that subtract the accumulated depreciation from it. The resultant figure is also known as net value of an asset.