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.
Leaving aside for a moment the reasons, which may be many, the simple explanation is that the market - which is to say those who partake in the buying and selling of companies' shares, via their bid-ask interactions - have arrived at a price which values the equity differently than the value determined by the company itself.
The market may arrive at a value greater or lesser than the book value. When seeking reasons behind the discrepancy, it may turn out to be something as subjective as consumer preferences reflected in brand loyalty. If a company's brand is highly regarded in its own market, despite the product it produces being objectively, virtually identical to that of other companies, the confidence or significance felt by consumers regarding the brand could lead them to value it more highly.
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.
Thus, though there are numerous potential explanations, the discrepancy between book and market valuing of a company's capitalization reflects the market's doubt about the company's book value. Understanding what this doubt is and whether it is soundly based is the key to an investment strategy that leverages market capitalization against book value.
The examples above show that there are numerous skills and insights one may draw upon to exercise such leverage: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Having some such edge is an important aspect of successful investing. Whatever yours may be, recognizing such discrepancies between true or immanent, as opposed to book, value of a company's assets, provide the opportunity for profitable investment.
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.
Leaving aside for a moment the reasons, which may be many, the simple explanation is that the market - which is to say those who partake in the buying and selling of companies' shares, via their bid-ask interactions - have arrived at a price which values the equity differently than the value determined by the company itself.
The market may arrive at a value greater or lesser than the book value. When seeking reasons behind the discrepancy, it may turn out to be something as subjective as consumer preferences reflected in brand loyalty. If a company's brand is highly regarded in its own market, despite the product it produces being objectively, virtually identical to that of other companies, the confidence or significance felt by consumers regarding the brand could lead them to value it more highly.
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.
Thus, though there are numerous potential explanations, the discrepancy between book and market valuing of a company's capitalization reflects the market's doubt about the company's book value. Understanding what this doubt is and whether it is soundly based is the key to an investment strategy that leverages market capitalization against book value.
The examples above show that there are numerous skills and insights one may draw upon to exercise such leverage: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Having some such edge is an important aspect of successful investing. Whatever yours may be, recognizing such discrepancies between true or immanent, as opposed to book, value of a company's assets, provide the opportunity for profitable investment.
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 who want to benefit from misvalued book equity should be keeping up with the hottest scoop 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 required reading for those looking to make sound monetary investments.
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