Various measurements are used to determine the actual value of a company’s stock. Creditors rely on such metrics to determine how much money a company is eligible to borrow, while investors rely on this information to make investment decisions.
Book value per share (BVPS) is one of the most watched financial metrics, used to analyze whether a stock is fairly valued.
What is the Book Value of a Share?
Book value is a financial measure used to indicate the value of a business according to its financial statements. The metric is calculated from a company's balance sheet upon deduction of total liabilities from a company’s total assets.
Conversely, book value per share is the equity available to shareholders divided by the number of outstanding shares. The measure represents the value of a company’s equity on a per share basis and provides a good baseline for valuing a company.
BVPS can also be envisioned as the sum amount of money that shareholders would receive in case a firm is liquidated, resulting in assets auctioned and liabilities deducted.
BVPS is a vital evaluation metric used by investors and analysts when trying to find the best stocks to buy. Book value should never be confused with market value as it is essentially an accounting value subject to management discretion.
Book value per equity share, being a ratio, is calculated by first deducting all the liabilities and obligations that a company might have from all of its assets and dividing the outcome by the total number of outstanding shares.
For example, if company XYZ’s total assets are valued at $200 million and it has total liabilities of $20 million:
Book Value = $200,000,000-$20,000,000= $180 million
What this means is that if a company sold off its total assets and paid down its liabilities, then the equity value or net worth up for distribution to shareholders is $180 Million. Shareholders equity, in this case, includes paid-up capital, retained earnings and revenue capital and any surplus generated from the revaluation of fixed assets.
In the case of a negative book value, it means a company’s liabilities exceed the value of assets, which leads to what is commonly known as balance sheet insolvency.
It is essential to use an average number of outstanding shares when calculating BVPS as stock issuances or buybacks could significantly affect end values.
BVPS is just one method of comparison for valuing a company, given that there are other metrics such as enterprise value, firm value, market value, relative strength and market capitalization, all used in different circumstances.
Investors are fond of companies that pay close attention to strategies that have the potential to increase BVPS, as it shows seriousness towards growth and shareholder value. Companies generating higher profits are usually in the best position to increase BVPS.
For example, a company that generated $500,000 in net earnings could decide to use $200,000 of the profits to buy assets that have the potential to increase capacity. This would not only increase the company’s book value but also lead to more production and more profits in the long run.
In addition, the company could decide to use $200,000 to reduce liabilities that eat into book value, thereby boosting common equity. Reducing liabilities is another way of boosting BVPS.
Repurchasing common stock through buybacks is another way that companies use to shore up BVPS. By reducing the number of shares in circulation, the company reduces the dilution of earnings per share.
What Should Be Considered a Good Book Value per Share?
It is impossible to pinpoint a specific value and declare it as a good book value per share that investors should watch for since companies come in all sizes and issue different amounts of shares. That said, by comparing the stock’s current market price to its book value per share, investors can get an idea of the stock’s value and the company’s potential growth prospects.
Value investors are known to pay closer attention to price-to-book value metric than to BVPS on its own when trying to analyze the true value of a company for investment purposes.
Differences Between BVPS and Market Value per Share
BVPS differs from the market value in the fact that it is calculated using historical costs. BVPS, being calculated from book value, gauges the actual value of a company’s assets versus liabilities.
Market value, on the other hand, is a forward-looking financial metric that tries to gauge a company’s future earnings power. Higher market value is most of the time associated with a company with a high growth rate that goes a long way in strengthening investor’s confidence in a stock.
A company that generates high income from assets will always possess a market value that is higher than book value, which is most of the time referred to as return on assets.
Book Value portrays the actual value of a company based on financial statements in books of accounts. Market value, on the other hand, is more of a prediction, which (whether accurate or not) tries to showcase the value of a company based on investors sentiments.
Consider two wholesale companies that both own a $1 million warehouse, $500,000 in inventory, have $200,000 of debt, and both have $100,000 in bills to pay to suppliers. Their book value might be the same, but their respective market values would be remarkably different from one another if one company is a fax machine wholesaler while the other is a wholesaler of a product with a lot of growth potential.
Market value tends to have a more meaningful implication in the stock market as it indicates the price that investors must pay to own a part of the business regardless of the company’s stated book value. That said, the two metrics differ a great deal given that they depend on various factors such as industry of operation, nature of assets and liabilities, among other attributes.
What is the significance of the book value per share?
Investors use Book Value per Share to ascertain whether a stock price is overvalued or undervalued when it comes to the average market value per share. If a company’s BVPS is higher than the current stock price, then the stock is perceived as undervalued. Conversely, if a BVPS is lower than the current stock price, then the stock may be considered overvalued.
BVPS also allows investors to assess the financial health of a company by simply looking at the value of assets as well as net liabilities. Increasing liabilities affect the net worth of a company which significantly reduces the book value of a company.
Investors use book value per share to determine a company’s actual value, relative to market value. For example, a company whose stock is trading at $30 but has a book value of $15 is considered selling at twice its equity. The measure is sometimes referred to as price to book value and is a reflection of the market’s sentiment regarding a company’s future growth potential.
BVPS is of great importance to value investors as a company with a higher book value than market value is usually considered a definite buy. A stock is deemed undervalued if its book value exceeds the market value thereby indicating cheap valuation.
Buying Stock Based on Book Value
Whenever the stock of a company is trading in the market at a much lesser value than the book value, then it means investors have lost confidence in the company’s prospects. In other words, investors have lost faith in the company’s ability to use its current assets to generate desired profits and cash flow.
It is common for value investors to go for companies whose market value is lower than the book value, in anticipation of market perception turning out to be incorrect. Such scenarios provide investors an opportunity to buy the stock of a company at a much lesser value than the stated net worth.
The financial metric examines market capitalization in relation to book value. A price to book value of less than 1 is considered a good value as it shows a stock may be undervalued. However, a low P/B could also point to a company with serious underlying problems.
Some companies also tend to inflate their book value in a bid to strengthen sentiments among investors. It is for this reason that the metric should never be used in isolation when making investment decisions.
Selling Stock-Based On Book Value
Whenever the market value exceeds the book value, then it means shareholders are assigning a higher value to a company because of growing confidence in the company's earnings power. Higher market value relative to book value is often found with profitable companies that have consistently beaten estimates.
A higher market value most of the time indicates that investors believe in a company’s growth prospects as well as expansion and potential for profits. Such companies appeal to growth investors.
However, if the investors are mistaken, then it might mean that a stock is overvalued, presenting an opportunity for value investors to take advantage of. As the ratio of stock price to BVPS climbs, investors who aren’t as optimistic about the company’s growth potential will enter short positions so they can profit in the event that the stock price comes down.
Whenever book value equals market value, then it means that investors believe that the company's earnings potential is neither higher nor lower than what can be expected based on the company’s balance sheet.
Book value per share represents the amount of money available for distribution to shareholders in the theoretical case of a liquidation. The financial metric depends on the industry a company is operating as well as how well it manages its assets and liabilities.
Companies expected to grow and generate higher profits command a much higher market value compared to book value. This is because investors buy such stocks aggressively as they look to take advantage of higher dividend yields and earnings per share which are the fruits of robust growth.
In contrast, when a company has a book value that is greater than its market value, that indicates that the market is pessimistic about a company’s ability to generate profits in the future. Investors should do their own research to decide if a low price-to-book value ratio is a sign of a good deal on a stock and when it is a sign of a stock that should be avoided.
BVPS should always be used to supplement other valuation approaches when trying to establish an opinion on stock value. Unlike earnings and cash flow approaches, this metric measures the value of a stockholder’s claim at any given point in time.
That said, BVPS is a useful financial metric that helps investors to gauge whether a stock may be overvalued or undervalued. Such information is always of great value when complemented with other financial metrics as it goes a long way in helping one make informed investing decisions.