The Investor's Scoop On Book Value Vs Market Capitalization
In an earlier article, I elaborated on what distinguishes book and market capitalization. Space constraints do not permit a detailed reiteration of those points, here.
It will have to be sufficient to explain that book value references the determination of a company's accountants and executives about the value of its equity: liabilities subtracted from assets. In contrast, markets distill prices for the value of the company, arrived at by share traders, in their exchanges. (To understand the basics in greater detail, see the link at the bottom of this article.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
What lies behind such erratic fluctuations will have to be discussed at another occasion. For present purposes, it is the reasons for the discrepancies between book and market capitalization and their relevance to investing which are of concern.
Putting the reasons aside just for the moment, the most basic explanation is that the market - i.e., those who buy and sell companies' shares, via their bid-ask interactions - arrive at prices with different valuations of a company's equity than that of the company itself.
The difference may be of course either more or less than book value. The potential reasons for the discrepancy may be any of many. It can be as simple a matter as brand recognition and estimation. Should a particular brand have a high enough cache or reputation with the relevant consumer base, virtually identical products may be differently valued in the market, allowing the stronger brand to successfully charge more.
Since consumers demonstrate their willingness to pay a brand premium, share traders way conclude that the very same capital at the company with the preferred brand is more valuable than at the company with the lesser brand. The literal book value is not disputed in this case. Additional considerations, though, lead the market to value the more popular brand in excess of formal book value.
Certainly, though, discrepancies can arise over disputation of a company's stated book value. For example, imagine a company with assets that include large tracks of undeveloped land. Let's say up to a certain point both the market and the accountants valued this asset at going real estate prices. Should it come to pass, though, that a large-enough group of share traders become convinced that the area in which the undeveloped land is situated is on the verge of a major real estate boom, such traders may regard the land and its assigned value in the book capitalization calculations quite differently. The company's shares may be perceived as significantly undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than the book value.
Naturally, of course, the process can unfold in the opposite direction. If the company in question works in an industry where new, onerous regulatory compliance costs will cut into profitability, those who foresee these developments far-enough in advance will recognize the book value of the company's liabilities as understated. The shares are determined to be overpriced. As a result, shareholders may lower their asking prices in hopes of unloading the overpriced shares and cutting their losses.
There may be a great number of possible reasons for discrepancies between the book and market value of any company's capitalization. They always though indicate some ambivalence on the part of the market about the accuracy of the company's book value. Recognizing both the reason and the validity behind such ambivalence is essential for a sound investment strategy, leveraging market capitalization against book value.
The illustrations above provide plenty of different manners in which diverse skills and insights can aid in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Possessing insight into any of these matters, or numerous others, can provide the opportunity to benefit from a book value that inadequately appreciates the true or immanent value of a company's equity. When you discover such a discrepancy the opportunity for profitable investment - whether under or overvalued - is available.
Understanding the difference between book and market value, and the process of market capitalization, we can see then is immensely valuable for investors. If this all presumes knowledge about market capitalization with which you don't feel acquainted, I suggest you follow up with my What is Market Capitalization article.
It will have to be sufficient to explain that book value references the determination of a company's accountants and executives about the value of its equity: liabilities subtracted from assets. In contrast, markets distill prices for the value of the company, arrived at by share traders, in their exchanges. (To understand the basics in greater detail, see the link at the bottom of this article.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
What lies behind such erratic fluctuations will have to be discussed at another occasion. For present purposes, it is the reasons for the discrepancies between book and market capitalization and their relevance to investing which are of concern.
Putting the reasons aside just for the moment, the most basic explanation is that the market - i.e., those who buy and sell companies' shares, via their bid-ask interactions - arrive at prices with different valuations of a company's equity than that of the company itself.
The difference may be of course either more or less than book value. The potential reasons for the discrepancy may be any of many. It can be as simple a matter as brand recognition and estimation. Should a particular brand have a high enough cache or reputation with the relevant consumer base, virtually identical products may be differently valued in the market, allowing the stronger brand to successfully charge more.
Since consumers demonstrate their willingness to pay a brand premium, share traders way conclude that the very same capital at the company with the preferred brand is more valuable than at the company with the lesser brand. The literal book value is not disputed in this case. Additional considerations, though, lead the market to value the more popular brand in excess of formal book value.
Certainly, though, discrepancies can arise over disputation of a company's stated book value. For example, imagine a company with assets that include large tracks of undeveloped land. Let's say up to a certain point both the market and the accountants valued this asset at going real estate prices. Should it come to pass, though, that a large-enough group of share traders become convinced that the area in which the undeveloped land is situated is on the verge of a major real estate boom, such traders may regard the land and its assigned value in the book capitalization calculations quite differently. The company's shares may be perceived as significantly undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than the book value.
Naturally, of course, the process can unfold in the opposite direction. If the company in question works in an industry where new, onerous regulatory compliance costs will cut into profitability, those who foresee these developments far-enough in advance will recognize the book value of the company's liabilities as understated. The shares are determined to be overpriced. As a result, shareholders may lower their asking prices in hopes of unloading the overpriced shares and cutting their losses.
There may be a great number of possible reasons for discrepancies between the book and market value of any company's capitalization. They always though indicate some ambivalence on the part of the market about the accuracy of the company's book value. Recognizing both the reason and the validity behind such ambivalence is essential for a sound investment strategy, leveraging market capitalization against book value.
The illustrations above provide plenty of different manners in which diverse skills and insights can aid in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Possessing insight into any of these matters, or numerous others, can provide the opportunity to benefit from a book value that inadequately appreciates the true or immanent value of a company's equity. When you discover such a discrepancy the opportunity for profitable investment - whether under or overvalued - is available.
Understanding the difference between book and market value, and the process of market capitalization, we can see then is immensely valuable for investors. If this all presumes knowledge about market capitalization with which you don't feel acquainted, I suggest you follow up with my What is Market Capitalization article.
About the Author:
Investors who want to benefit from misvalued book equity need to follow all the hottest tips at the Market Capitalization blog. Wallace Eddington is a widely published commentator on markets and finance. His recent article on fiat currency and inflation is a must read for those looking to make sound monetary investments.
