The book value of a company is the measure of shareholders equity on its balance sheet, which in turn is determined by subtracting the value of all of its liabilities from the value of all of its assets.
The book value of a share is determined by dividing the book value of the company by the number of common shares outstanding.
The book value of a stock enters into some of the ratios that analysts use to determine whether a stock's current share price is undervalued or overvalued.
The most direct way of using book value in stock analysis is the price-book value ratio, or PBV.
Since healthy firms are expected to grow over time, the PBV is usually above one. If the PBV is below one, that may be a temporary situation and, thus, a buying opportunity for a value investors. "Early in his career, Warren Buffett bought Illinois National Bank ... at less than book value," according to a 2006 article on website The Motley Fool. "Buying good companies at or below tangible book value limits downside risk and provides a margin of safety."
The significance of the PBV ratio is greatest in industries such as automobile manufacturing or the marketing of durable appliances, in which the companies have a lot of tangible assets. In other sectors, such as software or financial services, what a company sells is the know-how of its employees. These have low book values, and analysis based on PBV would be misleading.
Another limit to the significance of PBV is that the book value of a firm, and thus of its stock, depends upon many accounting decisions, such as the depreciation of assets, the estimation of good will and the valuation of intellectual property rights. One firm might follow different accounting conventions than another, and such differences would undermine any comparison of the PBV ratios of the two.
Tangible Book Value
One way to try to reduce your dependence on the judgment of accountants is to redefine the PBV ratio as price to tangible book value, on the theory that tangible assets are less dependent on accounting judgments than intangible ones.
Yet tangible assets are subject to tricky accounting decisions, too, such as the rate at which their value depreciates, or whether they ought to be marked-to-market on a regular basis.
Another use of book value is that it may allow an analyst to fix the "comprehensive earnings" of a company per share over the course of a period of time, typically a year. A balance sheet is often compared to a photo of a company's affairs at a given moment. Comprehensive earnings may be derived from comparing two snapshots.
The comparison has to include adjustments for management decisions that have the effect of re-allocating ownership between older and newer shareholders through a new issuance. As the website "Retail Investor" cautions, "Do not use the average (over the period) number of shares outstanding that is most commonly disclosed....All the analysis must be done on a 'per share' basis in order to incorporate the effects of changing ownership-interest."
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