Every investor would like to make his/her money work for his/her benefit. To generate wealth for one’s future needs while looking after present financial needs, one must invest in avenues that have a higher growth potential. An example of such an avenue is the equity market. However, while investing in equity markets, an investor has to exercise a lot of discipline and engage in thorough research before making any investment decision. One of the aspects of detailed research is knowing the book value of a company.
Here, we will explain the concept of book value per share and help investors understand its importance.
The book value per share (BVPS) is a calculation that takes into account the total equity available to common shareholders versus the number of shares outstanding. The book value per share, when compared to the current market value per share, can provide insight into how a company’s stock is valued.
If the BVPS is higher than the market value per share, the company’s stock may be undervalued. The book value is generally used as an indicator of a stock’s value and to predict the possible market price of a share at a given time in the future.
The calculation of book value per share of a company is based on the common stockholders’ equity, while the preferred stock is excluded from the value of equity. The exclusion is because preferred stockholders are given preference over common stockholders in case of company’s liquidation. The BVPS represents the value of equity remaining after repaying all debts and liquidating the company’s assets.
The formula for calculating the book value per share is given as follows:
BVPS = (Total Shareholders’ Equity–Preferred Equity)
Total Outstanding Common Shares
Book value per share is calculated by taking the sum of the company’s assets and subtracting debt, liabilities, and the liquidation price of a preferred stock from this. The result is then divided by the number of outstanding shares of common stock.
BVPS is mostly used by investors to understand if a stock price is undervalued. This is done by comparing the ratio to the company’s market value per share. Here are some of the ways in which it can be interpreted to help with an investment analysis:
- If a company’s BVPS is more than its current stock price, then the stock is undervalued.
- If the company’s BVPS rises, the stock could be more valuable and this can result in a rise in the stock’s market price
- If BVPS is negative, in case a company’s total liabilities are more than its total assets, it can be interpreted as balance sheet insolvency.
While this can be a good starting point for new investors to look for undervalued stocks in the market, these interpretations may not necessarily make the stock a good investment option. This may only indicate whether a stock is undervalued or overvalued and must be seen in combination with other factors like the company’s earnings record.
When the current price of the share of a company is divided by its book value per share, we get the P/B (price to book value) ratio. P/B ratio acts as a comparison tool while making an investment decision. Here is how we can interpret the results of P/B.
|P/B Ratio less than 1.0||Stock of the company is undervalued|
|P/B Ratio above 1.0||Net worth of company shares is bloated|
|P/B Ratio is equal to 1.0||Company stocks valued at par|
- P/B ratio is less than 0
If the P/B ratio is below 1.0, it means that the stock is undervalued. This can be an opportunity for value investors who wish to add undervalued stocks to their portfolio. This also means that in case the company goes bankrupt and liquidates, the shareholders can make a profit on their investment even after the company settles all its liabilities.
- P/B ratio is equal to 0
If the P/B ratio is equal to 1.0, the stock is valued at par. This is an indicator of the market indifference whether the company remains in the business or goes out of it. In such scenarios, investors may not lose anything or make any profit even if the company liquidates. Shareholder wealth remains unchanged after the company’s liabilities are settled. If the company remains in the business, the shareholders’ wealth may increase or decrease.
- P/B Ratio is more than 0
If the P/B ratio is higher than 1.0, the net worth of the company could be bloated. Investors may lose their money in case the company liquidates. While the company could benefit by remaining in the business, it may not make sense for investors to invest in this further.
Some of the limitations of Book Value per Share that investors should bear in mind are:
- The book value per share may not reflect the actual market value of a company’s shares.
- It’s based on historical costs, not current market prices, so it might be outdated.
- It doesn’t include intangible assets like brand recognition or intellectual property, which can add significant value.
- It assumes all assets can be sold at their recorded cost, which is often not the case.
- It doesn’t take into account future earning potential or growth prospects of the company.
- Changes in accounting rules can impact the book value calculation, making comparisons tricky.
- It’s just one financial metric, and should not be used alone to evaluate a company.
Book value per share is one of the many measures of stock selection and therefore, it should never be used in isolation. Investors must not buy a stock only because it is below its book value. Instead, they must focus on more research on the company’s performance and future goals to gauge its stock value.
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