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Fundamental analysis: Significance of book value in stock picking

Book Value is a valuation metric used to value an enterprise. It is the value of all the assets (current and non current) arrived at by deducting all the current and non current liabilities, depreciation, amortization and also the intangible assets (patents, goodwill etc.). Calculating the book value gives you the approximate value of the company if it were to get liquidated without considering the earnings of the enterprise.

WHAT KIND OF COMPANIES CAN BE VALUED USING BOOK VALUE

The valuation metric of book value is helpful in analysing certain type of companies.This metric is often ignored and only gets a passing reference compared to other valuation metrics so we are going to discuss it in detail.

Book value holds all the more significance when valuing

  1. Asset rich companies, Banks and Financial Companies. An example of asset rich company would be mining companies .These companies own mines and the ores available within the mine but it takes years before all of it gets extracted and comes to the market. Meanwhile ore prices keep fluctuating and there is no consistency in earnings. The only reliable way to value such companies is by using book value metric. When we talk about the banks all their assets are in dollars or financial in nature. They can be easily measured. After all dollar is worth a dollar. Banks trade on the basis of their book value.
  2. Companies which are going through a loss making period. In the absence of earnings book value is the only metric used by valuation experts.

IMPORTANT THINGS TO KNOW WHILE CALCULATING BOOK VALUE

While calculating the book value certain things have to be kept in mind while adding different assets

1) Cash in bank has to be taken @ 100 per cent of its stated value

2) Other assets like:

a) Tangible Assets

b) Capital work in progress

c) Non current investments

d) Long Term Loans and Advances

e) Current Investments

f) Inventories

g) Trades receivables

h) Short Term Loans and Advances

have to be taken into account by applying a discount factor.

We generally apply a discount factor of 60%. This is so because net realisable value of the assets generally turns out to be less than the stated value of Balance Sheet. To consider that fact we apply a discount factor. Please note that the above assets are representative in nature .There could be more or less asset entries in a particular balance sheet

The exception to this rule is when we calculate “Non Current Investments”. Typically in any accounting standard the non current or long term investment is carried on the balance sheet at its cost. For example a company has a non depreciating asset like land whose value generally increases with time. If may be carried at $1 million in the balance sheet but the market value could be $3 million dollars. If this difference is overlooked we may arrive at different book value and the analysis could turn out to be faulty.

To solve this problem we have to dig deeper and obtain the list of all their investments and try to assess their market value.This is not an easy job for a lay man or amateur investor. However if one look into the notes to accounts some details can be found there. Professional analysts do have better access to company data.

PRICE TO BOOK RATIO COMPARED WITH ROE AN INDICATOR OF VALUE

Price to Book Value is calculated by dividing market value of stock by its book value. Populary known as P/BV ratio it is a good indicator of value of the enterprise. It can tell us whether the stock is undervalued or overvalued when used with return on equity (ROE). Return on equity is calculated as net income/shareholders equity).

Analyzing the P/BV against the return on equity can throw some useful insight into underpricing or overpricing of a stock. The below given figure compares the market prices of the six biggest financial companies with its book value.

Looking at the figure one can easily see that Citigroup is trading below its book value.If we look at this fact in isolation we can conclude that citigroup is undervalued. But when we look at the ROE of citigroup which is 6.75% compared to the industry average of 11% that is when we realize that it may be correctly priced.

Disclaimer: The above figure has been taken from Market Realist who have quoted their source as Company Filings

In our next article we will discuss how to find profitable companies using ROE and ROCE. Stay tuned.

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Trading Risk Disclaimer

All the information shared is provided for educational purposes only. Any trades placed upon reliance of SharperTrades, LLC are taken at your own risk for your own account. Past performance is no guarantee. While there is great potential for reward trading stocks, cryptos, commodities, options, forex and other trading securities, there is also substantial risk of loss. All trading operations involve high risks of losing your entire investment. You must therefore decide your own suitability to trade. Trading results can never be guaranteed. SharperTrades, LLC is not registered as an investment adviser with any federal or state regulatory agency. This is not an offer to buy or sell stocks, cryptos, forex, futures, options, commodity interests or any other trading securities.

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