Why Is the Book Value of Equity Typically Less Than the Market Value?

Why Is the Book Value of Equity Typically Less Than the Market Value? thumbnail

Book value and market value are two metrics used by investors and analysts to determine the worth of a firm. Book value can be greater than market value under circumstances. It is typically less because book value basically represents the liquidation price of the firm if it went out of business today. The market value is a forward-looking metric that is based on the firm’s future performance expectations as an ongoing enterprise.

Book Value Defined

  • Book value is the value of the company at liquidation prices.
    Book value is the value of the company at liquidation prices.

    Book Value is the owners’ equity or the net asset value of the firm. This is the value obtained by subtracting all liabilities on the firm’s balance sheet from the total value of the firm’s assets. Since book value and market value are used by investors for stock analysis, these values are typically expressed on a “per share” basis. Book value per share is calculated by dividing the total book value of the firm by the number of common shares outstanding. Book value per share is relatively static. It does not change much over time, nor does it reflect market sentiment about expectations of the firm’s future stock performance.

Market Value Defined

  • Market value is the value of the company as an ongoing enterprise.
    Market value is the value of the company as an ongoing enterprise.

    Market value is commonly defined as the value of the firm as reflected by the current trading price of the firm’s outstanding common shares. This number is obtained by multiplying the total number of outstanding common shares by the most recent trading price of the stock on the open market. Unlike book value per share, the market value per share is a dynamic number because it reflects the stock’s future performance based on expected return on investment. It can be a highly volatile number because it is affected by a range of factors that impact market sentiment.

Stock Trading Exceptions

    Under certain circumstances, as noted, the book value per share of a firm’s stock can be greater than the market value. This can happen, for example, when a firm with valuable assets and few liabilities has exceptionally bad news that triggers a sell-off panic in the market. Consider, for example, a hypothetical pharmaceutical firm with a defective drug on the market that gets bombarded with a flood of class-action lawsuits. Short-term investor panic could drive the firm’s per share market value below its book value for the short-term until the panic subsides.

Book Value Ratios

    The book per share value is most commonly used by “value” stock investors in search of bargain stocks. Stocks trading with high book to market ratios are generally viewed as “candidate” value or bargain stocks pending closer analysis of the firm. Stocks with low book to market ratios would lack appeal to value investors. The book to market ratio is calculated by dividing the per share book value by the per share market value. Value investors use other ratios in addition to the book to market ration as tools to identify bargain stocks. The book to market ratio however is one of the most widely used ratios.

Intangible Assets

    As a general rule, book value is based on a calculation of the firm’s hard, tangible assets. Book value does not include intangible assets such as a firm’s investment in research and development. R&D investments are not included as assets on the firm’s balance sheet. Rather, they are expensed on the firm’s profit and loss statement. Many firms, especially high-tech firms, consider their investment in R&D to be their greatest asset. This anomaly has prompted some stock analysts to downplay the relevancy of the book to market ratio analysis. They claim that inclusion of R&D in the book value would make many high-tech stocks appear more attractive to value investors.

Related posts:

  1. Definition of Book Shares Stock
  2. How to Calculate Book Value Per Share of Common Stock
  3. How to Compute Book Value Per Share
  4. How to Determine Book Value Per Share
  5. How to Calculate Equity Per Share & Dividend
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