Book Vs Market Capitalization: What It Means For Investors
Elsewhere, I have explained the difference between how book and market capitalization is calculated. There won't be space to repeat that explanation at length here.
It's enough for our purposes, here, to observe that book value is a company's assessment of its own equity: determined by subtracting the value of total liabilities from the value of total assets. The value of that equity though is determined differently on the market: it generally responds to the shifts in demand, since it is rare for new shares to be issued. (Further detail on how these values are calculated can be found through the link at the end of this article.)
Book price is stable, though, if subject to sound accounting, it may change over the years, say, with depreciation of infrastructure and new liabilities. However, we all know that on the stock market prices exhibit none of this stability or orderly gradated adjustment. Rather, they tend to bounce around erratically.
The reasons behind the stock market's erratic fluctuations must await another discussion. For the moment we are only concerned with the fundamental reasons underlying discrepancies between book and market capitalization, as well as their relevance to investment strategy.
Putting the reasons aside just for the moment, the most basic explanation is that the market - i.e., those who buy and sell companies' shares, via their bid-ask interactions - arrive at prices with different valuations of a company's equity than that of the company itself.
The market capitalization may be more or less than the book value. There are plenty of potential reasons for this. Sometimes it is merely a matter of brand. If, for whatever reason, the company brand is highly regarded, product Y produced by it may simply be more highly valued by consumers than a Y produced by a company with a lesser brand.
So consumers will pay more for it; thus, due only to its brand, the capital to produce a Y is considered more valuable by the share traders. In this case the literal book value isn't disputed, but an additional consideration results in a market value greater than the book value.
Many discrepancies, however, are indeed a function of markets disagreeing with the stated book value of a company's assets. An example would be the situation in which a company's assets include undeveloped land. If the market, and the company's accountants, has valued the assets at prevailing real estate rates a potentially dramatic divergence of value could result if enough share traders re-evaluate the land. Say, for instance, they become convinced that the region in question is poised for a major real estate boom. At that point traders may now consider the land a significantly undervalued asset on the company's books.
Seeing the undervalued shares as a ticket to great profits they start bidding on them in great numbers, increasing demand for the shares and pushing up their price. The result is a market capitalization value greater than the book value.
The process of course can work the other way around, as well. Say the company is in a business whose industry faces new, onerous regulation, entailing major compliance costs. Those share traders who most quickly recognize the pending regulatory costs may perceive the book value of the company's liabilities as inaccurate. From their perspective, then, the shares could be regarded as overpriced, motivating them to unload them. Lowering prices to sell enables them to cut their losses.
There may be a great number of possible reasons for discrepancies between the book and market value of any company's capitalization. They always though indicate some ambivalence on the part of the market about the accuracy of the company's book value. Recognizing both the reason and the validity behind such ambivalence is essential for a sound investment strategy, leveraging market capitalization against book value.
As seen in the examples above, there are a variety of skills and insights one might bring to bear in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Whatever your own edge, if you can recognize where the market valuing of a company's capitalization fails to adequately appreciate the true or immanent, as opposed to book, value of a company's assets, the opportunity for profitable investment - whether buying or selling - has presented itself.
This is how understanding the difference between book and market value, and the process of market capitalization, is essential knowledge for investors. If this all presumes a knowledge about market capitalization with which you don't feel acquainted, please read my What is Market Capitalization article.
It's enough for our purposes, here, to observe that book value is a company's assessment of its own equity: determined by subtracting the value of total liabilities from the value of total assets. The value of that equity though is determined differently on the market: it generally responds to the shifts in demand, since it is rare for new shares to be issued. (Further detail on how these values are calculated can be found through the link at the end of this article.)
Book price is stable, though, if subject to sound accounting, it may change over the years, say, with depreciation of infrastructure and new liabilities. However, we all know that on the stock market prices exhibit none of this stability or orderly gradated adjustment. Rather, they tend to bounce around erratically.
The reasons behind the stock market's erratic fluctuations must await another discussion. For the moment we are only concerned with the fundamental reasons underlying discrepancies between book and market capitalization, as well as their relevance to investment strategy.
Putting the reasons aside just for the moment, the most basic explanation is that the market - i.e., those who buy and sell companies' shares, via their bid-ask interactions - arrive at prices with different valuations of a company's equity than that of the company itself.
The market capitalization may be more or less than the book value. There are plenty of potential reasons for this. Sometimes it is merely a matter of brand. If, for whatever reason, the company brand is highly regarded, product Y produced by it may simply be more highly valued by consumers than a Y produced by a company with a lesser brand.
So consumers will pay more for it; thus, due only to its brand, the capital to produce a Y is considered more valuable by the share traders. In this case the literal book value isn't disputed, but an additional consideration results in a market value greater than the book value.
Many discrepancies, however, are indeed a function of markets disagreeing with the stated book value of a company's assets. An example would be the situation in which a company's assets include undeveloped land. If the market, and the company's accountants, has valued the assets at prevailing real estate rates a potentially dramatic divergence of value could result if enough share traders re-evaluate the land. Say, for instance, they become convinced that the region in question is poised for a major real estate boom. At that point traders may now consider the land a significantly undervalued asset on the company's books.
Seeing the undervalued shares as a ticket to great profits they start bidding on them in great numbers, increasing demand for the shares and pushing up their price. The result is a market capitalization value greater than the book value.
The process of course can work the other way around, as well. Say the company is in a business whose industry faces new, onerous regulation, entailing major compliance costs. Those share traders who most quickly recognize the pending regulatory costs may perceive the book value of the company's liabilities as inaccurate. From their perspective, then, the shares could be regarded as overpriced, motivating them to unload them. Lowering prices to sell enables them to cut their losses.
There may be a great number of possible reasons for discrepancies between the book and market value of any company's capitalization. They always though indicate some ambivalence on the part of the market about the accuracy of the company's book value. Recognizing both the reason and the validity behind such ambivalence is essential for a sound investment strategy, leveraging market capitalization against book value.
As seen in the examples above, there are a variety of skills and insights one might bring to bear in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Whatever your own edge, if you can recognize where the market valuing of a company's capitalization fails to adequately appreciate the true or immanent, as opposed to book, value of a company's assets, the opportunity for profitable investment - whether buying or selling - has presented itself.
This is how understanding the difference between book and market value, and the process of market capitalization, is essential knowledge for investors. If this all presumes a knowledge about market capitalization with which you don't feel acquainted, please read my What is Market Capitalization article.
About the Author:
Investors eager to benefit from misvalued book equity need to follow the hottest scoop at the Market Capitalization site. Wallace Eddington is a widely published commentator on markets and finance. His recent article on fiat currency and inflation is required reading for those looking to make sound monetary investments.
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