Needless to mention that undervalued stocks are like a four-leaf clover for stock market investors.
Savvy investors are always on the lookout for undervalued stocks because it gives them opportunities to earn high profits at a low cost.
But, how do investors identify such stocks?
Well. The book value of a share is one metric that helps investors find an undervalued stock, and it is also a crucial financial tool to forecast the possible market price per share at a given time in the future.
In a precise manner, book value per share is the amount that the shareholders would receive at the time of liquidation of a company after paying off all its debt and selling its tangible assets.
If the market price of a share goes below its book value per share, one can make a tremendous profit during the company’s liquidation. This metric enables investors to understand whether the stock prices of a particular company are overvalued or undervalued by comparing the book value per share with the market value per share. if the book value is higher, it suggests that the company has potential in terms of assets and performance but the market has not been able to identify it yet which is why the market price is lower.
For instance, if a company’s book value per share is higher than its market value per share, it is considered undervalued. Similarly, if the book value per share is lower than the market price per share for a company, it is considered overvalued.
If you want to know how book value per share can analyse such crucial pointers, read on to understand it in detail.
Book value per share is the figure calculated by dividing the equity available to the shareholders with the total number of outstanding shares.
In the stock market, book value per share (BVPS) is a benchmark that investors can use to analyse how a company’s stock is valued.
The formula for calculating book value per share is as follows:
Book value per share = (Total equity of company – Equity available to preferred shareholders) / Total number of outstanding shares.
Or, we can also write this formula as,
Book value per share = Equity available to common shareholders / No. of outstanding shares.
To calculate book value per share, an individual needs to have these values:
In simpler terms, a company’s total equity is the net difference between assets and total liabilities. However, the total equity is a total of common stock, additional paid-in capital, and retained earnings from which treasury stock is deducted.
Total equity is also the difference between the total amount of paid out dividends deducted from the amount invested by investors in the company for buying its stock and other incidental earnings.
Preferred equity is the amount invested by investors who are given preference over common shareholders. To obtain the equity available to common shareholders, we deduct the preferred stock from shareholder’s equity.
Let us quote an example to understand the workings of book value per share clearly.
Assume a company named Wafira Ltd. has a stockholder’s equity value of INR 30,00,00. Out of the total equity balance, Wafira Ltd. has a preferred stock of INR 10,00,000.
The company also has 20,000 outstanding shares during the period. We need to know how to calculate the book value per share of Wafira Ltd.
To calculate the book value per share of Wafira Ltd., we need to know the value of the total equity balance, preferred equity of the company and the total number of outstanding shares.
Total equity balance of Wafira Ltd. = INR 30,00,000
Amount of Preferred equity in Wafira Ltd. = INR 10,00,000
Total number of outstanding shares = 20,000
The formula of book value per share is
Book Value per share = (Shareholders equity – Preferred equity) / Total number of outstanding shares.
Book Value per share = (INR 30,00,000 – INR 10,00,000) / 20000
Book Value per share = INR 20,00,000 / 20,000
Book Value per share = INR 100
The book value per share of INR 100 means that if Wafira Ltd. is liquidated today, it will leave a profit of INR 100 per share.
If a particular company needs to increase its book value per share, it can use its profit to buy assets.
For example, X ltd. generates INR 700,000 in earnings and uses INR 300,000 to purchase more assets, which will increase the common equity and raise the book value per share.
On the other hand, the company can also use INR 400,000 to reduce its liabilities and increase its common equity.
One way to increase the book value per share is to repurchase or buy back common stocks from shareholders.
Referring to the previous example, assume that the company bought back 40,000 common stocks from its shareholders, which will decrease the current shares outstanding to 1,60,000 (200,000-40,000).
Therefore, the revised book value per share is obtained as follows:-
Book value per share = INR 20,00,000/ 1,60,000.
Revised book value per share = INR 12.5
We can conclude that buying 40,000 shares increases Book Value per share from INR 10 to INR 12.5.
When an individual notices a company trading below its book value, two possible consequences are:
First, investors immediately label it as an undervalued company and dive right into investing in it.
Second, the investor believes the company inflates its net worth by incorporating aggressive accounting policies and ignoring them.
But, instead of focusing on the extremes, one should find a middle ground.
If you think the company is undervalued, gain insights into why other investors have not recognised it before investing your money.
Different companies account for their assets differently. This lack of standardisation is the reason behind that muzzy book value.
So, an investor must always look into the details of the book value before investing in a company.
The lucidity lacking in book value figures can leave investors woolly-headed about whether the investment is a value play (opportunity) or a value trap.
The depreciation policies of the company are evidence of its transparency. But, if you want to look at the depreciation policy of a company, you need to look at records for several years.
When a company depreciates an asset faster than its market value, it becomes the hidden gem investors have been looking for.
When a company depreciates an asset slower than its market value, it is trying to manipulate its P/B Ratio to lure investors into its value trap.
Investors that do not glance at other parameters and make decisions solely based on P/B ratio are victims of this value trap.
A good instance of this value trap is the manufacturing industry.
The manufacturing industry requires expensive assets, and the depreciation of these assets bought by a manufacturing company happens faster than the company’s expectations. The resale value of such assets falls quickly, and if the asset becomes obsolete, it becomes useless.
If someone wants to invest in a company with types of equipment as its significant assets rather than land or building, one needs to look into more parameters than just the P/B Ratio to make a worthy choice.
Manipulation of metrics is prevalent in the stock market, irrespective of the nature of the assets.
Companies have overstated value during the bullish market and understated value during the bearish market, and this change happens because of the market to market rules.
Hence, one must always consider a variety of financial parameters before arriving at a conclusion.
Investment experts say that book value tends to be manipulated constantly by companies. Hence, it becomes difficult to point out genuine investment opportunities in stock markets analysed in detail.
But, this manipulation has been in existence since the 1950s. However, this could not stop market-savvy investors from finding genuine book value plays.
Here are three tips that market-savvy investors swear by when finding out undervalued stocks suitable for book value plays.
Even if you have found an undervalued stock, it can still result in a loss. It would be best to wait for the market to arrive on the same page as you before planning to book a profit on your findings.
Investment experts and renowned investors can speed up the process, but individual investors have nothing but themselves, and an individual alone cannot influence the whole market. Hence, you can find the philosopher’s stone, but it might be of no use to you at the end of the day.
In such cases, digging deep into the book value can give you better insights into the company’s workings. You can understand the dividend payment policies of the company and then decide on your investment choice.
Looking into the book value will also tell you about the company’s internal issues. If a company has faulty assets, then a significant part of earnings might get diluted in repairing and maintaining such assets. Book value saves you from such value traps. Hence, digging into the book value is always a win-win.
Conclusion
Book value is a critical factor in investment analysis. It is also the most heavily manipulated metric, and thus an investor needs to do proper research to make well-informed decisions.
A good technique for making well-informed financial decisions would be to avoid taking book value as the only parameter of decision making. Looking at various financial metrics can help you gain a holistic picture of your investment choices.
Do not fall for the value trap by considering manipulated book value for your analysis. Theoretically, a low PB Ratio signifies undervalued stock, but in reality, it may be outdated assets adding to the book value. Hence, if your investment decisions are based on book value, then do not forget to use other financial metrics to find out the actual condition of a company’s assets.
There can be instances where an investor might see a share is trading below its book value. Some possible explanations for such activity could be:
Market value per share portrays the current price of a company's share and it is a forward-looking metric that considers the company's earning potential in a future period.
Alongside the company's overall growth and possibilities, the market value also increases, the price investors are willing to pay for given common stocks.
On the other hand, book value per share is used for accounting for the actual value of the company's stock that the stockholders will obtain at the time of liquidation of the company after dissolving all its assets and liabilities.
Book Value per share is calculated using historical costs, and unlike market value per share, it does not reflect the actual market value of the company's share.
If an investor is looking for a wise investment choice, they should not get swayed away by the book value ratio. It is essential to look at its assets before investing in them. Some companies tend to play down some critical information or reveal it in the notes to account section to prevent investors from paying heed to that information. Such companies are value traps.
A company can have financial problems while maintaining a good book value Ratio.
Like a company might be on the verge of bankruptcy, but they do not reduce the value of assets with loans secured against them.
In such extreme cases, book value happens to be the only proverbial straw for the company to cling onto.
Hence, investors should look out for inflated book value figures before making their investment decisions.
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