How Does Book Value Work?

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The world of investments is hard enough to understand, but there are some terms you need to know to dive into this ocean. 

Book value is only the tip of the iceberg, and to understand the working mechanism of all the systems, you should know the basics of investing movements.

Have you ever heard about book value? Today we are going to discuss such a necessary process. 

But our talk is about company finances. It is more challenging than getting a $200 loan no credit check or ordering a bad credit card. If you realize how any company’s financial system works, you need to be patient. 

So, let’s start. If we talk in simple words:

Book Value = the Assets – the Liabilities

What is considered assets: the price of any property, funds, and other goods belonging to the company.

What are liabilities: Firm’s expenditures and debts. Use book value if you are a novice investor and want to make the right choice to avoid losing money. 

It will help you determine whether a corporation’s shares are out of price or undervalued. Additionally, you will understand the actual value of this company.

But here are some usual terms that perhaps you should consider:

  • Price-to-earnings ratio (P/E) – the share’s price about the profit per share.
  • Projected earnings growth (PEG) – the price-earnings ratio to the rate of increase
  • Dividend payout ratio – the comparison of the number of dividends paid to shareholders with the whole net profit of the business.
  • Return on equity (ROE) – assessment of a company’s profitability in relation to the carrying amount of the shareholders’ equity of each shareholder.
  • Earnings per share (EPS) – the number of companies’ profits that goes into each share of stock.

Book Value: Examples

What amount of money would remain after selling all the assets and paying off all the outstanding bonds? The company’s book value is what you need!

Let’s assume that a company has an overall asset of $3 million and an unpaid liability of $2 million.

$3 million – $2 million = $1 million

In this case, the book value is $1 million!

The fact to know: The amount of Apple per share for the three-month period ending September 2022 is $3.18. Over the past 12 months, Apple’s average book value per share growth rate is -been 17.30% annually.

Link: https://www.rba.gov.au/publications/fsr/2015/mar/graphs/graph-1.13.html

According to the table above, the banks’ stock price relative to the book value has declined significantly since 2006 in the USA.

How to Use Book Value When Making an Investment

Imagine that you go shopping and your purpose is to buy a good suit as you have an essential meeting next Monday.  

Here you are, a person who wants to buy a costume. You have criteria by which you choose one. Probably, they are:

  • Material,
  • Color,
  • Quality.

Come back to investing. There are such criteria that are popular among value investment enthusiasts.

  • Book value,
  • Book value per share,
  • The cost is at book value.

“All that glitters is not gold.” Do you remember this proverb? Sometimes targeting the top-performing stocks isn’t the best option. 

So, this investment program is about finding a good deal. It searches for low-priced and overlooked stocks, hoping their prices will eventually recover. 

You have already understood that investors stick to some factors to find good deals, as they want to “wear a nice costume.”

  • Stock trades below its book value could become a great bargain.

The book value (per share) is put above its market price – which can demonstrate the underestimated value.

  • If the book value (per share) is below its market value – it may show an overpriced stock.

Why does it work in this way?

  • Book value per share – a firm’s financial soundness. Since the book value is based on its assets.
  • Market value per share – how attractive a company’s equities are to the market. 

Limitations on Book Value 

It is preferable to use the book value of corporations with physical assets.

For example, machines and other devices. 

What about companies that don’t have many material assets?

Facebook & Twitter can be attributed to this category. 

Why?

Because they are instances of companies mainly based on the idea of providing their service online.

Their assets are non-material. The enormous wealth is intellectual property.

In this case, if you are interested in calculating book value for companies like Facebook and measuring them against their market value, attempt to figure out why the book value number is that kind.

While speaking about such firms, it all works oppositely! 

The book value looks too big or too little in comparison with the market capitalization of this company. It may mean that the majority of the company’s assets are incorporeal. 

It may indicate something other than overstated or undervalued shares like in the first type of company.

Summing Up

Book value is one of the most accurate methods to evaluate companies, and investors worldwide use it wisely. 

It helps to understand the actual cost of all company’s assets, not including debts. 

Investors should know the total cost of assets minus all the liabilities of a particular organization. 

Book value can help to understand if the company is estimated correctly or overpriced, or vice versa. 

This helps to understand the company’s financial situation, weigh all the pros and cons, and make the right financially sound decision.

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