Concept 2: Book value

BOOK VALUE

Book value is basically an accounting measure. It can be computed by looking at the balance sheet of a company.

Book value is the net of what the company owns and owes recordically – Total of land, buildings, machinery etc… Reduced by the total of what it owes – liabilities like loans.

How to find book value?

The simple way to find book value is –

  • Book value = Equity share capital + Retained earnings

Both these figures are available in the company’s balance sheet. You can add the above said numbers to get the book value. The other option is to rely on financial websites where this information is available straight.

For example – The Balance sheet of Reliance communications is given in the following link. What you see is the last 5 years figures.(2007-2011) As you can see under the ‘sources of funds’ for march 2011, the Equity capital is Rs 1032.01 Crores and the retained earnings (Also called reserves)  is Rs 47,112.47 Crores.

  • Book value = 1032.01 + 47112.47 = Rs 48144.48 Crores
  • Total number of equity shares = 2,064,026,881 Nos. ..ll Check ll
  • Book value per share = 48144.48 Crores/ 206.40 = Rs 233.26 per share.   ll Confirm it here ll

Book value is what the company would realise should they stop the business and sell off all the assets they have.

PROBLEMS WITH BOOK VALUE.

Most investors think that all they have to do is to spot a company that’s trading below the book value and invest in that stock. But, things are not so easy. The book value as reflected from the balance sheet has some problems.

  • First, a company may have self generated assets like patents, trademarks, customer base etc which do not find Place in the balance sheet. Book value excludes such intangible items. So, book value is not much useful when it comes to valuing companies with huge intangible assets. For Example – software companies like Microsoft.
  • Second, the assets as shown in the balance sheet may not be properly valued. For example, if the company bought land worth 5 Crores in 1992, even 20 years later in 2012, the land will be shown at 5 Crores only. But in reality the asset value might be much more than that. Book value does not reflect such increase in value.
  • Third, Plant, machinery etc are shown at cost less depreciation. In reality, such plant may have depreciated much more. For example- Machinery worth lakhs in the balance sheet may be totally worthless because of technological changes. Hence it may not fetch the value as shown in the balance sheet.
  • Fourth, the value at which current assets like debtors and closing stock appear in the balance sheet has to be taken with a pinch of salt. Most retail firms carry their inventories at high cost. Debtors may default in their payments. So the value that appears as ‘current assets’ is always questionable.
  • Finally, the part that most of us forget to look- the liabilities side. A company may have pending litigations which may be unfavorable resulting in additional burden. Adequacy of provisions is another questionable area. Such potential liabilities are not reflected in the balance sheet figures.

Hence, book value may not be the right measure in all cases.

PRICE/BV RATIO

The price to book ratio or P/B ratio reflects the value the market places on the book value of the company. The price to book ratio is calculated as:

  • P/B ratio = market price per share / book value per share

The market price divided by book value shows the market value of every rupee of asset that the company has. For example if the P/B ratio is 4 it means that for every Rs 1 in books, the price paid by the market is Rs 4. Investors generally would like to have a P/B of less than 1 so that each rupee they pay is backed by more assets.

Price to book ratio varies between industries. Asset based companies like infra structure, banks and financial institutions may have high book values.

For investors, P/B is a tried and tested method for finding low-priced stocks.

The thumb rule is that –

  • Book values are useful to measure companies with huge tangible assets in their books like banks.
  • If a company is trading for less than its book value it tells investors that the stock is priced low.

Difficult to find a good stock that’s below book value?

That’s exactly how it is. Investors will be always willing to pay more than the book value for companies with strong profits and solid growth prospects. It would be very difficult to catch such companies at less than their book value. For example Microsoft, the software giant, has rarely traded below 10 times it book value.

So, if you find companies that trade below it’s book value, do not jump in and invest. May be something’s wrong with the fundamentals. You have to be very cautious in such cases. Book value thumb rules are valid if and only if the company’s balance sheet is strong and it’s business is not in troubled waters. Otherwise, an undervalued share might mean that one of two things:

  • Either the market believes that the asset value is overstated or
  • The company is earning a very poor (even negative) return on its assets.

That’s the concept of book value for you..

Next one is Margin of safety.

.. have a nice day!

You may like these posts:

  1. Understanding price to book ratio
  2. Concept 1: Intrinsic Value.
  3. Balance sheet components: Assets

12 Responses to “Concept 2: Book value”

5 Investment concepts | Basics of Share Market

January 26, 2012 at 2:18 pm

[...] Concept 2: Book value [...]

Mansoor

January 26, 2012 at 11:01 pm

Ha ha, It addressed all my questions I had commented in the concept 1 Victor. Thanks.

Hardik

September 4, 2012 at 1:23 pm

Nice explanation :)

J Victor

September 9, 2012 at 11:12 am

Thanks :)

K.K.Narayanan

September 19, 2012 at 1:13 pm

Very clear explanation.Thanks.

Parthiban

October 29, 2012 at 3:09 pm

Excellent !

Parthiban

October 29, 2012 at 6:48 pm

During a market slump/crash, does the Market price of the Share tend to correct itself towards book value or previous ceilings of high and low ? Your observations based on your experiences in the market please !

J Victor

October 29, 2012 at 8:04 pm

i have not observed any such solid relation between market crashes and share price movement.

sanket

February 9, 2013 at 11:37 pm

simple & great article, thanks

J Victor

February 17, 2013 at 10:16 am

Thankyou ..

nipun

April 13, 2013 at 6:09 pm

very good work . keep it up victor

Mazhar

June 26, 2016 at 5:00 pm

Very nice explanation I really appreciate it.

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