Understanding Book Value For Investors
Why is Book Value Important For Investors?
The ratio of the Price to Book Value can help investors understand if they are getting good value in buying a share. On its own it often indicates little or nothing. But it can back up an opinion about a stock arrived at in another way such as the Price / Earnings (“P/E”) ratio. In combination with the P/E ratio and other analysis the Price to Book Value Ratio can help identify bargains and help investors avoid over-priced stocks. All serious investors should understand the Price to book Value Ratio and its implications.
How is Book Value Calculated?
Book Value means the value of the equity that is owned by shareholders according to the financial statements. Book Value is calculated from the Balance Sheet. Book Value is usually shown directly on the Balance Sheet as the total equity value. Usually the total equity (Book Value) is a subtotal that adds up the value of the original common share dollars invested in the company at the IPO and any secondary offerings including amounts received for warrants and options plus retained earnings. (Often there are a few other smaller items added in, such as gains or losses on foreign exchange rates). Alternatively, Book Value can also be calculated as the total Asset value minus all items on the liability side of the balance sheet that are not part of common equity.
Book Value is also referred to as the net asset value since it is the value of assets net of (after subtracting) all debts and liabilities of all kinds. However in recent years net asset value has also been used to mean net market value of assets rather than the accounting book value.
Some companies use preferred shares. These should not be included in the calculation of Book Value. Some companies (legally but rather annoyingly) show these preferred shares in the same subtotal as common equity and in that case they have to subtracted out.
How is Book Value per Share Calculated?
Unless you are Warren Buffett you are not likely going to buy the whole company. Therefore, you are interested in Book Value per share. To calculate Book Value per share divide Book Value by the current diluted number of common shares outstanding. Often the number of shares is shown directly on the income statement. The diluted number of shares can also be calculated by dividing the latest quarter net income by the diluted earnings per share in the latest quarter. (If there has been a share issue in the quarter this will not be completely accurate but it is usually close enough). Additionally you can find the number of shares in the notes to the financial statements, under “common shares”. Ideally you should use the diluted number of shares but you can use the actual number of shares at the quarter end if the diluted number is not provided.
Book Value per share is also known as the net asset value per share since it is the book value of assets per share net of (after subtracting) all liabilities per share.
What is the Price to Book Value Ratio?
The Price to Book Value ratio is calculated by dividing the market price of the shares by the Book Value per Share calculated above.
Most companies trade above Book Value and therefore the Price to Book Value Ratio is typically greater than 1.
Is the Book Value Per Share the “true” value of the Assets Per Share?
Absolutely not! You may see Book Value described this way but it is not true. Book Value per share is the accounting value per share. There is absolutely no guarantee that the assets could be sold for the accounting value in the event of a liquidation of the company. In almost all cases where a company is liquidated and sold off as assets, it is a distress sale situation. In that kind of situation the market value of the assets would usually be much less than the accounting value.
Conversely, the assets could have a market value that far exceeds the accounting value. This could occur, for example, with a company that has land on its balance sheet that has appreciated in value over the years.
Only in rare cases does Book Value tend to approximate the true market value of assets. Most corporations are valued for the earnings that the assets produce and not for the assets as such.
Can Book Value Per Share be Trusted to mean anything?
In many cases no, but it can give a directional signal and can be a red flag to indicate when a stock may be over or under priced. It would seldom ever be a reliable indicator on its own, but can be a secondary indicator.
Does Leverage Impact the Reliability of Book Value?
Leverage means the amount of liabilities on the balance sheet in relation to the common shareholder’s equity. In an extreme case if there is no debt or other liabilities, then all of the assets belong to shareholders. In this case Book Value is relatively more reliable. For example if the assets were sold at 95% of accounting value then the shareholders would receive 95% of Book Value.
At the other extreme, if liabilities amount to 95% of assets and the common equity amounts to only 5% of assets, then Book Value (also called net asset value) is almost completely unreliable. In this highly leveraged case if the assets are sold at 95% of the accounting value then there is nothing left for the shareholders. It is important to remember that in liquidation the common shareholders get paid last, only after all other liabilities are paid.
If the assets are very liquid in nature (easily converted to cash), then the Book Value may be relatively reliable even with a high debt ratio. Conversely, a combination of assets that are not easily converted to cash and a high debt ratio would mean that the common shareholder could not count on getting anything in the event of liquidation, so the Book Value would be meaningless in that case.
Why Do Most Shares Trade Above Book Value?
The goal of a corporation is to make a high return on invested common equity.
It makes perfect sense that if an established company is earning a high return, they are not going to sell you a part of it at Book Value, they will want some premium.
If an existing corporation is making a sustained 20% return on equity, then this is an excellent, highly profitable company. An existing shareholder is not going to sell you his shares at Book Value. If the shares are making a 20% return on Book Value, then the share price will usually rise. The existing shareholder might be willing to sell you a share for twice Book Value. In this case you should expect to make 10% on your investment. Since you paid twice Book Value. The company is earning 20% and you paid twice Book Value, so you would expect 20% / 2 = 10%. And as earnings are retained, if the company keeps on making 20%, you will expect to earn 10% on your original investment but 20% on the reinvested retained earnings.
Another reason that companies trade above the accounting Book Value is that the accounting figure is designed to be conservative. For example, land typically appreciates in value due to inflation but this is not recorded in the accounting figures. Also when a company is first starting it typically loses money due to spending on start-up costs or even research costs. These costs are meant to be an investment for the longer term but in the interest of being conservative, these costs are expensed rather than recorded as investments.
Why Would Some Companies Trade Below Book Value?
This can easily happen with unprofitable companies. Imagine a company that has invested heavily in assets which turn out not to be capable of generating a profit. If the assets consist of mostly equipment and processes it may not be worth much as salvage. So logically the company may not be worth much.
In 2003, examples of companies trading below Book Value were Nortel and JDS Uniphase. These companies purchased assets and paid prices that were “over the moon” for mostly intangible assets that turned out to be worth only a few pennies on the dollar. In this case much of the assets were recorded as goodwill or intangible and in fact turned out to close to worthless. Prior to writing off billions in goodwill, these companies did trade below Book Value.
A mining company is sometimes allowed to capitalize its costs to search for minerals. But if none are found, then the so called asset can be worthless.
Are “Hard Assets” more valuable than intangible assets?
No, not necessarily. Hard assets like, cash, accounts receivable, inventory to some degree, and residential and commercial real estate are likely to have significant value even in the event of a liquidation situation. Often we might not expect 100 cents on the dollar but at least there should be some significant return. (However, a large discount to 100 cents would mean the equity owners might get nothing if the debt leverage is high).
Intangible assets like goodwill and patents may have no value if if the company can’t generate earnings. On the other hand goodwill and intangibles can be extremely valuable in many cases. These assets prove their worth by producing earnings. But unlike cash and hard assets, they may have zero value if they can’t produce earnings.
Some hard assets can also be of very little value. Specialized equipment may have little or no salvage value.
In general, assets are valued for their earnings power. If the earnings power is not there, it is rare that the assets will return full Book Value. And since the debts must be paid first, it is even more rare that assets really offer that much protection to shareholders in the event of liquidation.
Does Cash Per Share Matter?
You sometimes hear analysts say that a certain company has so many dollars per share of cash. That in itself tells you little. It is rare indeed that there would be net cash left after subtracting debts. But it can happen with research companies that have raised a pile of money and have little or no debt. But in those cases the company is very intent on spending that cash (they actually refer to it as the burn rate – an analogy that is often frighteningly accurate) so the cash as such has little to do with valuation.
How Does Book Value Relate to Dilution?
When a company issues shares they almost always do so at a price above Book Value. This increases the Book Value per share and tends to help put a valuation floor under the shares. Buyers of the newly issued shares suffer dilution in that for every $1.00 paid, they usually get less than a dollar in Book Value. The existing shareholders benefit from an accretion in Book Value per share.
This is confusing because the existing shareholders will often claim that they are suffering a dilution. In fact they usually are suffering a dilution of earnings per share, at least initially, but they usually are getting an accretion in Book Value per share.
A share prospectus may tell investors the amount of dilution they are suffering. It should make you nervous when the dilution is more than about 25%, particularly for an Initial Public Offering. High dilutions can be justified by proven high earnings. But if you are being asked to suffer a large dilution to buy into a forecast of expected (rather than proven) earnings then you are obviously into a higher risk situation. Buyers in the stock market, who are interested, can calculate their own Book Value dilution figure which is calculated as 1 minus (1 divided by the Price to Book Value Ratio).
How Does Book Value Relate To Return On Equity and Return On Market Value?
A company that is expected to earn a 20% return on equity (“ROE”) would be a great investment – if you could buy it at book value. Investors should be interested in the return on their investment. The inverse of the P/E ratio tells you the initial earnings yield on your investment. For example a P/E of 20 is an earnings yield of 1/20 = 5%. The Earnings yield or return on market value can also be calculated as return on equity divided by the price to book value ratio.
A stock with an ROE of 20% and a price to book value of 1, has an earnings yield of 0.20 / 1 = 0.2 or 20%. The inverse of this is the P/E ratio and is an attractive 1/0.2 = 5. This looks like a bargain stock. However if the price to book value is 4 then the the earnings yield in 20% /4 = 5%, the P/E is 1/0.05 = 20. Now it is does not look so attractive.
The ROE tells you how attractive and profitable the underlying business is. You can then divide that figure by the price to book value to see the initial return yield on your investment.
A mathematical relationship between P/B and ROE and P/E is as follows:
P/B = ROE times P/E
(Technically in the above formula use Return on Ending Equity rather than the more common Return on mid-year equity, but the result will usually not be much different).
This formula directly illustrates why some companies have a high P/B ratio. A company with a high ORE and a modest or high P/E is going to have a high P/B ratio.
A value investor basically cannot insist on both a high ROE and a low P/B. That can only happen if the P/E is very low which is probably unrealistic, given a high ROE. In screening for stocks you cannot screen for more than two of the variable in the equation. Otherwise you are “over-constraining” the problem.
How Can Investors Use the Price to Book Value Ratio?
If a share is trading at twice Book Value, then this means that you are paying double the accounting value for your share of equity when you buy the share.
Companies trading below Book Value absolutely are not necessarily bargains, in fact they could be worthless. Only in very rare cases could you be confident that buying assets at less than book value would guarantee a good return. For example, if you were very sure that the assets had a reliable market value that was higher than the price you were paying, then that would likely be a good investment. Even in that case you would have to be sure that management would be willing to liquidate the assets and disburse the cash to you. In most cases a company trading below book value has a very poor or negative ROE. It is usually a mediocre company and in most cases the assets are not liquid enough to be sold for more than pennies on the dollar. Still, exceptions do exist and it is worth investigating companies that trade below book value despite having a reasonable ROE based on book value.
A share trading at more than at most 3 to 4 times Book Value is often (but not always) a danger sign. A company that has found the mother of all gold deposits or has found a cure for cancer could, in theory, be worth a huge multiple of Book Value. But the higher the Price to Book Value ratio then the more of that potential value is already being priced-in by the seller of the shares, leaving less up-side potential for today’s investor. If an existing company is making a sustained 20% return on book equity and they want to sell me a share at twice Book Value, then I am okay with that. But if they want to sell me a share at 10 times Book Value, then I get extremely nervous. That would imply they are going to make huge returns on book equity such as 50% or 100% in order to give me an initial return of 5% to 10% on my market value. I’m probably not going to take that bet.
The Book Values of mining and research oriented companies are almost completely meaningless. A cancer vaccine company could easily be worth anywhere between 0 times and 100 times (or more) Book Value. In this case Book Value is of almost no relevance. Book Values of companies that have made major acquisitions are also unreliable since we can’t be sure if they paid too much for the acquisitions.
Book Value is of most guidance when the company is a mature company that has earnings. Your main valuation decision should be based on earnings and cash flow and growth per share outlook. However, a Price to Book Value ratio that is within a reasonable range can add a fair amount of comfort to your decision. Book Value is also of more relevance when the company is not extremely leveraged. If the equity represents 30% or less of the assets, then the Book Value becomes increasingly unreliable.
The ideal scenario is to find a company that appears to be under-valued on a P/E basis, where the ROE is high, where earnings growth is sustainable and predictable, and which is also (of mathematical necessity, given the low P/E) selling at an attractive Book Value ratio, say less that 2.0, and where the net-asset value after liabilities seems reliable. The higher the price to book value then the higher the ROE and or growth in earnings per share is needed to insure your investment makes sense.
Shawn Allen, CFA, CMA, MBA, P.Eng
March 29, 2003
Last edited, January 20, 2007