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Going by the Book

Using Book Value in Making Investment Decisions

Heading the list of questions investors sometimes struggle to answer is the perennial “What’s this stock worth?” The response is never simple, since there are several ways of assessing value. One of the most reliable ways is to use a combination of ratios, also called multiples. The BetterInvesting methodology employs the price-earnings ratio, which compares the stock’s price with its earnings per share.

 Investors also measure a company’s stock price in relation to entries on its balance sheet. One of those ratios is price-to-book, or a stock’s market price divided by book value per share.
A stock’s book value, also called its net asset value and sometimes its shareholder equity, is key to figuring its price-to-book. Even if you don’t use price-to-book in your analysis, you should understand what book value is because it’s part of the calculation of return on equity, a key measure of management performance on the Stock Selection Guide.
Basically, book value is the company’s assets minus its liabilities, divided by the number of outstanding shares. The liabilities include the obligations the company has to its bondholders and preferred stockholders.
Some stock research companies report price-to-book over time, such as 10 years, as well as percentage growth in book value. You can also calculate book value on your own, using the company’s financial reports. You find net assets by subtracting the company’s short- and long-term liabilities from its assets. Then divide net assets by the number of outstanding shares to find the per-share results.
Two cautions: Check what’s being counted as assets. If intangibles such as goodwill or brand value are being included, those amounts should be subtracted to determine net assets. Also, as a related point, book value is more meaningful for companies that have actual physical assets that can be valued.

What P/B Tells You

Book value is important because it can help you determine whether a stock you may be interested in is underpriced and therefore potentially worth purchasing.
If the market price of a stock and its book value are the same, its price-to-book value is said to be 1. In that case, investors are paying exactly the value of the company’s reported assets. If the ratio is more than 1, they’re paying for past performance or what they anticipate the company’s future performance will be. That’s quite common, especially for companies with strong earnings.
Conversely, a ratio of less than 1 may indicate investors aren’t convinced that the assets the company is reporting are credible. It also may signal that the company’s performance has been disappointing or the stock is out of favor with investors for some other reason. Questionable valuation of assets, of course, is a reason to steer clear of the stock, while the latter instance, which is remediable, may be a reason to consider buying.

One for the Books

Both book value and price-to-book change constantly as a stock’s market value and the number of its outstanding shares continually fluctuate. As a result, these numbers are “snapshots” that report the present but can’t predict the future.
If you’re just beginning to investigate a stock, however, book value is a useful benchmark to watch as you track the issuing company over time. That’s especially true if you’re looking at a number of stocks in the same sector or industry, since the price-to-book value can be strikingly similar across companies of varying sizes in the same industry. One that’s out of sync may be a stock that merits closer attention.
As you study a stock, putting its price-to-book and percentage growth in book value in a historical context can be helpful in establishing a target price you’re o use this ratio want a sense of where the current price fits in relation to earlier highs and lows in helping them pinpoint a price range that would allow them to realize a satisfactory return.

Putting Value in Perspective

Book value and a price-to-book ratio, by themselves, should never be the single basis for making an investment decision, any more than the ROE, EPS or P/E should be. But each can be a valuable addition to your research toolbox, and used in combination they can provide a valid foundation for choice.


Virginia B. Morris is the Editorial Director for Lightbulb Press.

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