What is the significance of book value

Celebrities make money because of intangible factors -- fame, good looks, acting skills, etc. Thus, as a celebrity, my current assets and debts net worth would have no bearing on my future earnings. Microsoft, like the celebrity, is not balance sheet-driven, and thus tangible book value is of little use in valuing these types of companies. Asset-driven companies So what kind of companies ARE balance sheet-driven?

Suppose that, instead of becoming a celebrity, I decide to become a gambler. As a gambler, I need capital to bet, so my net worth is critical in trying to forecast my future earnings. In this case, intrinsic value is closely tied to tangible book value. What kinds of companies fit this profile? Most financial service companies -- such as banks, insurance companies, and mortgage lenders -- whose assets can be converted to cash, as well as homebuilders, are generally valued based at a multiple of tangible book value.

These companies are balance sheet-driven because they use tangible assets to make money. Track record While it's always great to buy companies at or below their tangible net worth, it's also important to make sure tangible book value isn't going to shrink. If a company has a history of losing money, or has skeletons in the closet such as litigation issues or, for insurance companies, hurricane loss exposure, then tangible book value is likely to erode as assets are disposed to pay off losses.

Furthermore, if a company has a poor history of capital allocation, then tangible book value is likely to decrease. Using book value in investment decisions So to simplify, when calculating book value, tangible assets and liabilities should be revalued to current market values. Then investors should decide whether the company's future earnings depend on its tangible assets or not.

If the company's future earnings are balance sheet-driven, as is the case with many financial institutions, then investors should view tangible book as a rough estimate of liquidation value, and try to pay close to, or below, tangible book value in order to limit downside risk.

Early in his career, Warren Buffett bought Illinois National Bank, which by many measures was one of the best and most profitable banks in the nation, at less than book value. Buying good companies at or below tangible book value limits downside risk and provides a margin of safety. Microsoft and Coca-Cola are Inside Value recommendations.

Bank of America is an Income Investor selection. Take the newsletter of your choice for a day free trial. Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy. Discounted offers are only available to new members. If the company is embracing aggressive accounting policies in order to overinflate its net worth.

How do companies increase the book value per share? It can reduce liabilities using its profits; resultant, its common equity and book value per share will increase. It can use its earnings to buy back shares. Such a situation reflects balance sheet insolvency, and the stock may not be a good investment option.

The price-to-book value shows whether a share is undervalued or overvalued. On the other hand, book value per share gives you the value compared with its market value per share.

Author Recent Posts. Ayushi Mishra. Content Writer at Tickertape. I am all about good food, poetry and investments. Latest posts by Ayushi Mishra see all. Nov 11, Submit Type above and press Enter to search. Press Esc to cancel. Despite these differences, or because of them, investors often set a company's book value and market value against each other to determine if the shares are overpriced or underpriced — and so whether the stock's a good deal or not. Book value can be seen basically as a company's break-up value — the amount that the company would be worth if it were liquidated.

Book value is best used with companies that have significant physical assets, such as manufacturers that own factories and plants, heavy machinery, and other equipment. It doesn't work as accurately for companies whose assets are primarily intangible assets, such as info-technology or digital firms, whose assets lie primarily in intellectual property — their formulas, systems, algorithms, etc. Book value alone is just a reflection of a company's equity — what it owns.

To be used as an decision-making tool, it needs to be compared to a company's market value before an investor can determine whether to buy or sell a stock.

Market value is also known as market capitalization , is the value of all of a company's stock in the marketplace. It's what it would cost you if you were to buy up every one of its outstanding shares at the current share price.

It can be calculated by multiplying the share price by the total number of shares that are trading. Market value can be a volatile figure. It changes throughout the day because a company's share price constantly fluctuates, as investors and traders buy and sell the stock. For the most part, though, the number doesn't change very drastically; it only happens if there is significant good news or bad news related to the company or to the industry in which it operates. Total shares outstanding almost never changes, only on rare occasions when company's enact stock buybacks or issue more shares of stock.

You don't have to choose between using book value and market value. The real advantage for investors lies in comparing these values to one another for a specific company.

If book value is higher than market value, it can mean an undervalued stock. If the book value is lower, it can mean an overvalued stock. So if the book value of a company is higher than its market value, it means that investors are not factoring in its actual financial fundamentals — the strength of its operations and balance sheet.

It can mean a good opportunity to purchase a company's stock as its share price will most likely appreciate, once the market realizes the company's intrinsic strength.