The Investor's Scoop On Book Value Vs Market Capitalization

By Wallace Eddington

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.)

Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.

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 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 difference may be of course either more or less than book value. The potential reasons for the discrepancy may be any of many. It can be as simple a matter as brand recognition and estimation. Should a particular brand have a high enough cache or reputation with the relevant consumer base, virtually identical products may be differently valued in the market, allowing the stronger brand to successfully charge more.

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.

Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than 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.

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.

The illustrations above provide plenty of different manners in which diverse skills and insights can aid in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Possessing insight into any of these matters, or numerous others, can provide the opportunity to benefit from a book value that inadequately appreciates the true or immanent value of a company's equity. When you discover such a discrepancy the opportunity for profitable investment - whether under or overvalued - is available.

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 misvalued book equity need to follow all the hottest tips at the Market Capitalization blog. Wallace Eddington is a widely published commentator on markets and finance. His recent article on fiat currency and inflation is a must read for those looking to make sound monetary investments.