Equity markets have undergone several changes in
recent years. These developments have
influenced not only investment strategies but also
valuation methods. Equity valuation models can mainly
be seen in two ways—the value when one assumes that
the company has no growth rate, and when one would be
expecting earnings growth of the company. A wide range
of investors frequently revalue their stocks on the basis
of expected earnings announced either by the media or
research houses. It is a proven fact that for a growth firm,
the major components of valuation consist of the
expected future earning, but for a company whose growth
rate is negligible, its book value could be a good measure,
as it represents the value of assets that are distributable
to the shareholders in case of liquidation. In a study done
by Business Daily it was observed that the “market seems
to favor a combination of book value and dividends as the
main valuation parameter over earnings, book value and
dividends or a combination of book value and earnings
and book value plays an important role as a single
parameter, mainly in loss-making companies.”
Book value is defined as the net worth per share of the
company. The net worth is a portion of liabilities in the
balance sheet which belongs to the equity shareholders of
the company. Since in the balance sheet, the value of the
asset represents at historical price (Accounting Value)
and doesn’t change over a period of time, it is known as
book value. Further, the book value of assets is constant
in nature. While measuring the book value, one
generally does not take the intangible assets (i.e.,
goodwill, patents, etc.), current liabilities and preferred
stock into consideration.
As the book value does not consider the actual replacement cost of assets and the
value of intangible assets, s feel that the book value cannot be a good measure of
the intrinsic value of a stock. In this context, the legendary investor Warren Buffet’s
contribution cannot be ignored. He suggested that intangible assets were the assets
which continuously produced profits without any maintenance cost and cannot be
ignored in calculation of book value. When explaining about the economic goodwill, he
opined that, “Businesses logically are worth far more than net tangible assets when
they can be expected to produce earnings on such assets considerably in excess of
The question is what exactly represents the book value of a company? And how can
one use book value in deciding whether to buy or sell the stock? In simple terms, book
value is the value of the company’s assets, which are receivables to the equity holders at
the time of winding up of a company. In calculating and interpreting book value some
caution is required. Companies or industries with high liquid assets or where the assets
represent true value of assets at current market price could provide better results. For
example, a banking company, where a major part of the assets represent lending and
there is little difference between market value of assets and book value, it could provide
better results, but a hotel where the major part of the asset is land, building and
furniture, which is valued at historical cost, may not represent a realistic measure of
intrinsic value. Similarly, in IT companies, where a major part of the assets includes
computers which are fully depreciable within one year could represent book value less
than the replacement cost. Further, it doesn’t make any sense for a company in the
FMCG sector, as a major portion of its stock price will contain the growth factor.
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