In other words, if you wanted to close the doors of the business, how much money would be left after you sold off all the assets and settled all the outstanding obligations? That’s the company’s book value. For instance, suppose a firm has a total of $2 million in assets and $1 million in outstanding liabilities. Its book value would be $1 million.
Alternate terms: Net worth, shareholders’ equity
How to Use Book Value When You Invest
Book value on its own doesn’t give you a lot of data about the real value and potential return of a company. For instance, just because one company has a net worth of $1 million and a second has a net worth of $2 million, that doesn’t mean the second is always the better place to put your investment dollars. That’s why people who use it often look at book value and how it relates to other metrics to compare different stocks. One way to compare companies is to convert to book value per share, which is simply the book value divided by the number of outstanding shares. To build upon the example from above:
The first company has a book value of $1 million and has 100,000 shares outstanding. Its book value per share is $10.The second company is worth $2 million and has 10,000 shares outstanding. Its book value per share is $200.
Another common practice people use is to compare price-to-book ratios across companies. This ratio compares a company’s price per share to its book value per share. To build on the earlier example:
The first company has a book value per share of $10 and a market price of $50 per share. Its price-to-book ratio is 5.0. Investors are likely to see this as a stock that has been overvalued.The second company has a book value per share of $200 and has a market price of $100 per share. Its price-to-book ratio is 0.5. Investors are likely to see this as a stock that has been undervalued.
As you can see, the first company looked like the better choice at first, but a deeper dive has raised some red flags.
The Limits of Book Value
Another factor in looking at book value is the fact that it doesn’t factor in intangible assets, such as as patents, copyrights, and trademarks. While these assets aren’t tangibly valued on a company’s books, they offer a lot of value over time. Other limits of what book value shows are that it uses historical cost for pricing certain assets that may have gone up quite a bit over a long period of time. Real estate used and owned by the company often comes to mind. What’s more, book value may not provide a clear picture when a company with a large amount of capital assets is using an aggressive depreciation method. In both cases, the book value could be higher than simple assets minus liabilities would show. For these reasons, you should always look at other valuation metrics that deal with factors outside book value.
Other Vital Values for Investors
You won’t want to jump in with both feet on an investment until you have a firm grasp of many other aspects of a stock’s value. Here are a few other common terms you might want to look into and make sure you understand:
Earnings per share (EPS): This is the amount of a firm’s profit that goes to each share of stock. Price-to-earnings ratio (P/E): This measures the current price of a share against per-share earnings. Projected earnings growth (PEG): This looks at the price-to-earnings ratio compared to the growth ratio. Price-to-sales ratio (P/S): A company’s market cap is divided by its most recent yearly revenue. P/S can also be found by dividing the price of a stock per share by per-share revenue. Dividend payout ratio: This figure compares the number of dividends paid to stockholders vs. the company’s total net income. Dividend yield: This is a percentage of the current price of a share, derived by dividing a firm’s annual dividend over the current price of a share and then multiplying by 100 to get a percentage. Return on equity (ROE): ROE evaluates a company’s profitability in relation to the book value of each shareholder’s equity.
