Book Value
There are many methods of appraising a company or its stock. One of the simplest, and a method that can be used to evaluate any company is what its net assets are worth—what is commonly referred to as book value. Companies whose stock sells for less than book value is generally considered to be undervalued, or having less risk than companies selling for greater than book value. Because most companies sell for much more than book value, a company selling for less than book value may well have considerable upside potential.
In fact, 1 of the 10 rules listed by Benjamin Graham in his classic book on value investing, Security Analysis, states that the stock price should be less then 2/3 of the firm's book value minus any values for goodwill or other intangible assets. Often, however, a company sells for less than book value because it is financially troubled, or because the market thinks the company’s prospects are bleak.
The book value of a company’s stock is simply the stockholders' equity per common share of stock, which is equal to the net asset value, which is equal to total assets minus intangible assets, such as goodwill, minus total liabilities minus equity related prior claims, which includes preferred stock and cumulative dividends in arrears, divided by the number of outstanding common shares. Treasury stock, which is the repurchase of outstanding stock by the company, is not include in outstanding shares.
Net Asset Value for Common Stock = Total Assets - Intangible Assets - Total Liabilities - Equity with Prior Claims = Stockholders' Equity
| Book Value per Common Share Formula | ||
|---|---|---|
| Book Value per Common Share = | Net Asset Value ────────────────────────────── Number of Outstanding Common Shares | Treasury stock is not included. |
Book value can also be calculated for bonds and for preferred stock. Note that because bonds are senior to preferred stock which are senior to common stock, their corresponding net asset values are greater, and, consequently, their corresponding book values are greater.
Bond Book Value > Preferred Stock Book Value > Common Stock Book Value
Example — Calculating Book Value for a Company with Preferred Stock
If- Total Stockholders' Equity = $10,000,000
- Number of Common Shares = 1,000,000
- Number of Preferred Shares = 1,000
- Call Price of Preferred Shares = $104
- Book Value for Common Shareholders = ($10,000,000 - (1,000 x $104))/1,000,000 = $9.90 per Share
Example — Calculating Book Value for a Company with Preferred Stock and cumulative Dividends in Arrears
If, using the above example- Par Value = $100
- Annual Dividend Rate = 10%
- Number of Years Dividend Not Paid = 2
- Total Dividends not Paid = 100 x 10% x 2 x 1,000= $20,000
- Book Value for Common Shareholders = ($10,000,000 - $20,000 - (1,000 x $104))/1,000,000 = $9.88 per Share
Liquidation Value
The liquidation value of a company is equal to what remains after all assets have been sold and all liabilities have been paid. It differs from book value in that assets would be sold at market prices, whereas book value uses the historical costs of assets.This is considered to be a better floor price than book value for a company, because if a company drops significantly below this price, then someone, such as a corporate raider, can buy enough stock to take control of it, and then liquidate it for a riskless profit.
Of course, the company’s stock price would have to be low enough to cover the costs of liquidating it and the uncertainty in what the assets would actually sell for in the marketplace.
Q Ratio — Tobin’s Q
Another theory related to book value is that a firm cannot sell for much less or much more than the replacement cost of its assets minus its liabilities, which is quantified by the Q ratio, also known as Tobin’s Q, because it was developed by James Tobin, who hypothesized that the total market value of all companies must be relatively equal to the replacement value of their assets minus their liabilities.For an individual company, the Q ratio is equal to the market price of the firm divided by its replacement cost.
| Tobin's Q Ratio Formula | |
|---|---|
| Q Ratio = | Market Price of Firm ──────────── Replacement Cost |
If the Q ratio is significantly less than 1, then it would be cheaper for potential competitors to buy the firm rather than start a new business, so this would tend to increase its market price. If it sold for significantly more than the Q ratio of 1, then competitors would enter the market, and drive down the price of the firm until it was approximately equal to 1.
Because the replacement cost of a company would be difficult to ascertain quickly, the Q ratio cannot be a driving force in determining daily stock prices for companies. However, it could be an indicator for long-term trends and as a potential takeover target if the company’s Q ratio is less than 1.
If individuals or companies want to enter a business, certainly it would be an important consideration whether they could buy a business for less than what it would take to replicate the company by starting from scratch, especially since an established company would already have customers.
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