In an earlier article, I elaborated on what distinguishes book and market capitalization. Space constraints do not permit a detailed reiteration of those points, here.
It will have to be sufficient to explain that book value references the determination of a company's accountants and executives about the value of its equity: liabilities subtracted from assets. In contrast, markets distill prices for the value of the company, arrived at by share traders, in their exchanges. (To understand the basics in greater detail, see the link at the bottom of this article.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
What lies behind such erratic fluctuations will have to be discussed at another occasion. For present purposes, it is the reasons for the discrepancies between book and market capitalization and their relevance to investing which are of concern.
Leaving aside for a moment the reasons, which may be many, the simple explanation is that the market - which is to say those who partake in the buying and selling of companies' shares, via their bid-ask interactions - have arrived at a price which values the equity differently than the value determined by the company itself.
The market may arrive at a value greater or lesser than the book value. When seeking reasons behind the discrepancy, it may turn out to be something as subjective as consumer preferences reflected in brand loyalty. If a company's brand is highly regarded in its own market, despite the product it produces being objectively, virtually identical to that of other companies, the confidence or significance felt by consumers regarding the brand could lead them to value it more highly.
Since consumers demonstrate their willingness to pay a brand premium, share traders way conclude that the very same capital at the company with the preferred brand is more valuable than at the company with the lesser brand. The literal book value is not disputed in this case. Additional considerations, though, lead the market to value the more popular brand in excess of formal book value.
Certainly, though, discrepancies can arise over disputation of a company's stated book value. For example, imagine a company with assets that include large tracks of undeveloped land. Let's say up to a certain point both the market and the accountants valued this asset at going real estate prices. Should it come to pass, though, that a large-enough group of share traders become convinced that the area in which the undeveloped land is situated is on the verge of a major real estate boom, such traders may regard the land and its assigned value in the book capitalization calculations quite differently. The company's shares may be perceived as significantly undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than the book value.
Naturally, of course, the process can unfold in the opposite direction. If the company in question works in an industry where new, onerous regulatory compliance costs will cut into profitability, those who foresee these developments far-enough in advance will recognize the book value of the company's liabilities as understated. The shares are determined to be overpriced. As a result, shareholders may lower their asking prices in hopes of unloading the overpriced shares and cutting their losses.
Thus, though there are numerous potential explanations, the discrepancy between book and market valuing of a company's capitalization reflects the market's doubt about the company's book value. Understanding what this doubt is and whether it is soundly based is the key to an investment strategy that leverages market capitalization against book value.
The examples above show that there are numerous skills and insights one may draw upon to exercise such leverage: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Having some such edge is an important aspect of successful investing. Whatever yours may be, recognizing such discrepancies between true or immanent, as opposed to book, value of a company's assets, provide the opportunity for profitable investment.
Understanding the difference between book and market value, and the process of market capitalization, we can see then is immensely valuable for investors. If this all presumes knowledge about market capitalization with which you don't feel acquainted, I suggest you follow up with my What is Market Capitalization article.
It will have to be sufficient to explain that book value references the determination of a company's accountants and executives about the value of its equity: liabilities subtracted from assets. In contrast, markets distill prices for the value of the company, arrived at by share traders, in their exchanges. (To understand the basics in greater detail, see the link at the bottom of this article.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
What lies behind such erratic fluctuations will have to be discussed at another occasion. For present purposes, it is the reasons for the discrepancies between book and market capitalization and their relevance to investing which are of concern.
Leaving aside for a moment the reasons, which may be many, the simple explanation is that the market - which is to say those who partake in the buying and selling of companies' shares, via their bid-ask interactions - have arrived at a price which values the equity differently than the value determined by the company itself.
The market may arrive at a value greater or lesser than the book value. When seeking reasons behind the discrepancy, it may turn out to be something as subjective as consumer preferences reflected in brand loyalty. If a company's brand is highly regarded in its own market, despite the product it produces being objectively, virtually identical to that of other companies, the confidence or significance felt by consumers regarding the brand could lead them to value it more highly.
Since consumers demonstrate their willingness to pay a brand premium, share traders way conclude that the very same capital at the company with the preferred brand is more valuable than at the company with the lesser brand. The literal book value is not disputed in this case. Additional considerations, though, lead the market to value the more popular brand in excess of formal book value.
Certainly, though, discrepancies can arise over disputation of a company's stated book value. For example, imagine a company with assets that include large tracks of undeveloped land. Let's say up to a certain point both the market and the accountants valued this asset at going real estate prices. Should it come to pass, though, that a large-enough group of share traders become convinced that the area in which the undeveloped land is situated is on the verge of a major real estate boom, such traders may regard the land and its assigned value in the book capitalization calculations quite differently. The company's shares may be perceived as significantly undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than the book value.
Naturally, of course, the process can unfold in the opposite direction. If the company in question works in an industry where new, onerous regulatory compliance costs will cut into profitability, those who foresee these developments far-enough in advance will recognize the book value of the company's liabilities as understated. The shares are determined to be overpriced. As a result, shareholders may lower their asking prices in hopes of unloading the overpriced shares and cutting their losses.
Thus, though there are numerous potential explanations, the discrepancy between book and market valuing of a company's capitalization reflects the market's doubt about the company's book value. Understanding what this doubt is and whether it is soundly based is the key to an investment strategy that leverages market capitalization against book value.
The examples above show that there are numerous skills and insights one may draw upon to exercise such leverage: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Having some such edge is an important aspect of successful investing. Whatever yours may be, recognizing such discrepancies between true or immanent, as opposed to book, value of a company's assets, provide the opportunity for profitable investment.
Understanding the difference between book and market value, and the process of market capitalization, we can see then is immensely valuable for investors. If this all presumes knowledge about market capitalization with which you don't feel acquainted, I suggest you follow up with my What is Market Capitalization article.
About the Author:
Investors eager to benefit from misvalued book equity should be keeping up with the hottest scoop at the Market Capitalization blog. Wallace Eddington is a widely published commentator on markets and finance. His recent piece on fiat currency and inflation is a must read for those looking to make sound monetary investments.
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