Evaluating a company's worth can be challenging when there are many components to factor in, but long-term investors must be able to understand how to assess the worth of a company before investing in it.
This is where book value and market value measurements come in.
Investors wanting a glimpse into a company will consider its stock price to get an idea of the market value and turn to the book value to understand the value of the business. Looking at both figures can help investors decide if a stock is worth buying.
What is book value?
Book value is the value of a business as it pertains to its books, or accounts, as reported on the company's financial statements – particularly its balance sheet. It's used to determine the real value of a company. The value represents the total amount a company would be worth if it liquidated all of its assets and paid all of its liabilities.
This is the amount the company's creditors and investors are expected to receive if the company is liquidated. It's also the value of a particular asset on a company's balance sheet after taking depreciation into account.
"For this reason, book value tends to be less useful for valuing growth companies or companies that have a large amount of intangible assets," says Lacey Cobb, director of advice solutions at Personal Capital in San Francisco.
"It also tends to favor companies that are more capital intensive, so it's important to make sure you are comparing metrics of similar companies," Cobb explains.
Here's the book value formula:
Book Value = Total Assets – Liabilities
For example, if the ABC Company (ABC) has total assets of $500 million and total liabilities of $85 million, the company's book value would be $415 million. This means that if ABC liquidated its assets and repaid its liabilities, its intrinsic value would be $415 million.
Despite the widespread use of book value, the metric comes with disadvantages. One of its drawbacks is its inability to quantify intangible assets, such as a company's copyrights, trademarks or brand. Intangible assets are not listed on a company's financial statements and can be difficult to measure, but it's an important component to factor into a company's overall value.
Many companies today have strong intangibles, and for this reason, book value may seem detached from a corporation's value.
Book value can be reviewed every quarter when a company releases its earnings report, showing the company's assets and liabilities.
This important metric is meant to represent the intrinsic net worth of a company, and it can be used to help investors determine if a stock is undervalued or overvalued.
What is market value?
A company's market value is the value of a stock traded on public markets. It's the cost or financial worth of a company according to the financial markets, otherwise viewed as the price shareholders are willing to pay for a company's stock. Market value determines the maximum price at which a stock can be bought and can be calculated at any point.
The market value changes constantly in the marketplace, says Stephen Akin, investment advisor at Akin Investments in Biloxi, Mississippi. "The stock of a company may change rapidly depending upon company developments and market conditions," he says.
The factors that go into calculating this measurement are the stock's market price and the outstanding number of shares. By multiplying both of these figures, investors determine the company's market capitalization, or the market value of a company:
Market Value = Market Price x Number of Outstanding Shares
For example, if the XYZ Company (XYZ) is trading at a current market price of $100 per share and has 5 million shares outstanding, XYZ's market value would be $500 million.
This metric reflects the current market price and addresses the value the stock market assigns to each share of the company's stock. Market value is useful for value investors as a guiding indicator for when to purchase stock at a low price.
A disadvantage to using market value is that the metric can change from one moment to the next, especially if there is market volatility that influences the price of a stock. In addition, market value may not be the best measurement to use when comparing companies in similar or different industries.
A company's management team also looks at the market value of its stock for new issuances. If a company is looking to enhance the value of its stock, it could buy back its own shares. This is done to improve a company's balance sheet and can be seen during market swings. Additionally, when there is a merger or acquisition event, market value comes into play. If a company has a strong market value, this can be used as leverage in a merger and acquisition transaction.
Several drivers determine a stock's market value, such as earnings reports, investor sentiment about current and future prospects and the existence of stock buyback programs. Long-term investors seeking a stable investment look to market value for both current and forward-looking valuations.
Book value is a measurement frequently used by value investors.
This metric differs from market value because it's the shareholder's equity, whereas market value is the real-time market price or the amount the investor would receive if they were to sell the stock at its current market price. Both book and market value work together to determine the valuation of a company's intangible assets.
Value investors should use both metrics, as should all investors, says Sahak Manuelian, managing director of equity trading at Wedbush Securities in Los Angeles.
"Book value is a starting point and the market value will aid the investor in determining whether or not the investment is of value or if it is a momentum investment at this juncture. The fundamentals matter, and without both metrics it will be difficult in determining what is a 'value' stock," Sahak explains.
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