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'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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
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.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
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.
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.
Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company's shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over 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.
As we've seen, then, numerous potential reasons may lie behind the discrepancy between book and market value. In all cases, though, this discrepancy reflects the judgment of a large-enough number of traders that the company's actual value is not accurately reflected in its book value. For the successful investor, early recognition of such a situation and sound assessment of its validity is the key to successful 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.
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'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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
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.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
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.
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.
Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company's shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over 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.
As we've seen, then, numerous potential reasons may lie behind the discrepancy between book and market value. In all cases, though, this discrepancy reflects the judgment of a large-enough number of traders that the company's actual value is not accurately reflected in its book value. For the successful investor, early recognition of such a situation and sound assessment of its validity is the key to successful 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.
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 mistakenly valued book equity should be keeping up with the hottest scoop at the Market Capitalization site. Wallace Eddington is an insightful 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.
This article collected, selected and written by: Author Van Hoc
Niche blogs are sometimes referred to as splogs, but this is a misnomer. Even though the desired end result for the niche blogger is to make money...
Get Free Email Updates to your Inbox!
Post a Comment