For a new investor evaluating a company’s worth can be challenging, as the stock market has several components to consider for identifying the right stocks. But an investor must assess the worth of a company to invest wisely. This is where book value and market value parameters come into play. They present a glimpse of a company to the investors and give them an idea whether the stock is worth buying or not.
What is a book value?
Book value is the amount that shows a company’s worth when it is liquidated. It is calculated from a company’s balance sheet where the total value of intangible assets like copyrights, patents and intellectual property, and liabilities such as loans, taxes and other debts are deducted. The formula is:
Book value = Total Assets – Intangible assets – Liabilities
Let us understand with a small example – If a company has total assets worth Rs 20 crores out of which 2 crores is intangible assets and liabilities equals 7 crores, then the book value amounts to be 11 crores as per,
20 crores – 2 crores – 7 crores = 11 crores
This value can be beneficial to understand the value of manufacturing companies that have significant physical assets in the form of machinery, plants and equipment, and IT companies whose intangible assets include intellectual property in their formulas, systems and algorithms.
Book value also represents a company’s value of shares issued. However, the metric is not adequate to determine if a stock is worth buying or selling. It needs to be compared with market value.
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Comparison between book and market value will help investors to determine if a stock is undervalued or overvalued given its asset and liabilities.
What is market value?
Market value, also known as market capitalisation, is the value of the company’s stocks in the stock market. It is calculated by multiplying the share price by the total number of shares that are trading. The formula for market value is:
Market Value = Current Market Price Per Share x Total Shares Outstanding
Market value fluctuates throughout because a company’s share price constantly varies as investors sell and buy stocks.
The difference between market value and book value
Book value is the valuation of the company that considers hard financial figures ie. actual assets and liabilities, whereas market value is the valuation determined by its share price, which fluctuates based on the investor’s perception.
Updated numbers: Book value is not an updated value, since it is taken from the company’s financial statements that come quarterly or annually, therefore, the value can change from one reporting to other without any information that happens within the period. Market value information is available throughout the day.
Accuracy: Market value sometimes may not be accurate as it is based on investor’s perception. While in book there is a chance of manipulating the financial figures but yet it is an insightful number that indicates the financial health of the company.
Using book value and market value to determine the right stocks
When book value is higher than the market value it means that the stock is undervalued. It also means that investors are not considering a company’s actual financial numbers from the balance sheet and the strength of its operations. In this case, purchasing a company’s stock can prove to be beneficial as its share price is likely to increase and give better returns on selling, once the market realises the company’s intrinsic strength.
If the book value is lower than the market value, it means that the stock is overvalued or overpriced. Investors holding shares of such companies should either sell the stock or not buy, as the market correction will cause the share price to drop.
If the market value of a company is above its book value but starts to fall below its book value, it indicates a loss of investor confidence in the company.
Book value and market value are two different calculations that indicate a company’s overall financial strength. Comparison between the two will help investors to determine if a stock is undervalued or overvalued given its asset, liabilities, and its ability to generate income.
