Book Value And Market Capitalization: An Investor's Guide
Elsewhere, I have explained the difference between how book and market capitalization is calculated. There won't be space to repeat that explanation at length 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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
So consumers will pay more for it; thus, due only to its brand, the capital to produce a Y is considered more valuable by the share traders. In this case the literal book value isn't disputed, but an additional consideration results in a market value greater than the 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.
Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company's shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over the book value.
It can likewise work the other way around. If the company is in a business which a large enough number of share traders become convinced will soon be subject to new, onerous regulation that will entail massive compliance costs, their conclusions could be that the company's book value of its equity insufficiently accounts for its actual liabilities. The shares are considered overpriced and shareholders start lowering prices to unload them and cut their losses.
As we've seen, then, numerous potential reasons may lie behind the discrepancy between book and market value. In all cases, though, this discrepancy reflects the judgment of a large-enough number of traders that the company's actual value is not accurately reflected in its book value. For the successful investor, early recognition of such a situation and sound assessment of its validity is the key to successful 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.
This is how understanding the difference between book and market value, and the process of market capitalization, is essential knowledge for investors. If this all presumes a knowledge about market capitalization with which you don't feel acquainted, please read 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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
So consumers will pay more for it; thus, due only to its brand, the capital to produce a Y is considered more valuable by the share traders. In this case the literal book value isn't disputed, but an additional consideration results in a market value greater than the 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.
Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company's shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over the book value.
It can likewise work the other way around. If the company is in a business which a large enough number of share traders become convinced will soon be subject to new, onerous regulation that will entail massive compliance costs, their conclusions could be that the company's book value of its equity insufficiently accounts for its actual liabilities. The shares are considered overpriced and shareholders start lowering prices to unload them and cut their losses.
As we've seen, then, numerous potential reasons may lie behind the discrepancy between book and market value. In all cases, though, this discrepancy reflects the judgment of a large-enough number of traders that the company's actual value is not accurately reflected in its book value. For the successful investor, early recognition of such a situation and sound assessment of its validity is the key to successful 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.
This is how understanding the difference between book and market value, and the process of market capitalization, is essential knowledge for investors. If this all presumes a knowledge about market capitalization with which you don't feel acquainted, please read my What is Market Capitalization article.
About the Author:
Investors who want to benefit from mistakenly valued book equity need to follow all the hottest tips at the Market Capitalization site. Wallace Eddington is an insightful 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.
posted by Vittoria @ April 07, 2014
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