Sunday, August 28, 2011

How Investors can use Book Value to evaluate shares?

The balance sheet of a company is composed of the following important parameters

From the Balance Sheet statements of a company, a very important valuation ratio called book value of a company can be calculated. Book Value is one of the most used after valuation tools by the investor. Just by looking at the book value of a company and comparing it with market price of a share (P/B) will give you the first hint that whether a share is overpriced or underpriced.

So let us understand what statements in Balance sheet makes book value
When we speak of book value, we mean that minimum value at which the company will be sold in case of liquidation of company (company’s existence is brought to an end). In order to liquidate, we must know what

Company’s minimum value is? We have to list down all tangible assets (those items that can be sold for money) and its present value (after depreciation). So in the above table, on the extreme right corner you will find list of tangible assets.

In order to calculate Book Value one has to reduce the total value of tangible assets by the value of debts that company owns (account payables) called as liabilities on balance sheet:

Book Value = Assets – Liabilities

Suppose a share is trading at $10 per share. Its book value is $12 per share. It means if the company is liquidated and the money collected is distributed among the shareholders, then for each share they own, they will get $12. In this case the investors will be under profit of $2 per share as compared to the case if they decide to sell the share at the market price. Or in other words we can say that if a share is trading at a market price less than its book value per share, it means the share is undervalued and it can be bought at these levels.

Balance Sheet
Net Worth
Equity Capital 
-          Capital collected by the company during IPO. This can also be recognized as shareholders capital (money invested by shareholders in a company during its IPO).

Retained Earnings
-          All companies retain a part of their net profits. This money gets accumulate year after year in the balance sheet statements.
-          taken by company to manage working capital

Current Liability
-          Payables to vendors
Current Assets 
-          Investments
-          Inventories
-          Cash in bank/ hand
-          Fixed Deposits
-          Account receivables
Net Block
-          this is the total of all assets acquired by the company minus the depreciation. This is the actual value of asset that they are worth to company
Capital Work in progress
-          The money stuck in manufacturing of a product which is not yet finished and can be sold in the market.

But this calculation is not as simple as it is written. Why?
Let us see…
It is true that the share is trading at price less than the book value, but the questioned to be asked here is why? Investors must know that very often companies willingly publishes wrong (higher) book value in their statements. This will confuse the investors and they will be drawn to buy its shares assuming it to be undervalued.

It is also a fact that at times market wrongly prices a share. This mainly happens if for some reason a company gets un-noticed (low trading) for long time. May be other options are more lucrative and people concentrated more in those shares and because of this a particular share gets ignored.

The value of assets of company gets depreciated each year. At times companies does not deprecate the values as stated in the rule-book. This makes the value of assets to inflate and book value is quoted at higher rates than actual. In this case turn pages of some older balance sheets and compare what percentage of depreciation was deducted in say last five years. If you see any sudden drop in percentage you know that there was a trick. Let us take example of an auto industry. It takes huge capital expenditure (for buying machinery etc) to install a plant. In case of liquidation of such company, the amount that can be collected by individual machinery will be worth much less than the cost paid to buy them.

Hence in accounting principles, the logic of ‘depreciation of assets’ was introduced. As an investor we must be aware that if company is depreciating its assets as required then we may end up in calculating a wrong book value. As an investors we are more concerned that at what price these equipments will be sold in the market in case of liquidation. So very often we shall not blindly believe the book value figures quoted by companies in its balance sheets.

Suppose you an individual has an earning of $1,000 per month. Now you want to by a car which costs $25,000. You will need a car loan to buy this car. When you will approach you bank, they will say that your monthly income is not sufficient to grant you a loan of $25,000. Instead they will suggest you to take a loan by giving additional guarantee of say your house, two wheeler, etc. Here what your bank is doing is, it is trying to make itself comfortable that in case you are not able to repay back the loan amount they can liquidate these assets of yours (house, two wheeler etc) to recover their amount.

In this case if we calculate your book value, a financially intelligent person will not consider your house, two wheeler as your asset. As they are tied (like under dispute) with your auto loan. Similar conditions are applicable with the companies. When a company is in a bad financial condition, they tend to put a part of their asset (like land, building, cars etc) under guarantee/ security. While declaring its assets in the balance sheets, these companies are not obliged in not to include such disputed property. Instead they play safe and some where in the fine footer notes they include a statement confirming this type of transaction. But majority of investors do not read those fine prints.

The moral of the story is one must be careful in considering Book Value as their sole tool to evaluate whether the share is undervalued or overvalued. We must understand that why we are buying a share which is trading at a discount to its book value? The reason is, it open a door for fast price appreciation. As we have discussed below, if suppose a company is really underpriced as compared to its book value, then soon the market will recognize this and will start buying. With increased demand the market price will increase. In this case (you as an investor) one can sell their holding for huge profits. But if you have miscalculated the book value then instead of price appreciation, the market may fall further.

So what is the solution?
The solution lies in more in-depth research about companies financial health. Instead of considering Book Value as their only way of evaluating a share value, better to use other tools in parallel like PEG Ratio, Dividend Yield, Residual Income Method, frequency of dividend paid, Earning Yield Method, Earning stability, Price Earning Ratio, etc.
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