The difference between book and market capitalization and how it is calculated is a matter I've addressed elsewhere. Space constraints prevent repeating the explanation at any length.
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.)
Book price is stable, though, if subject to sound accounting, it may change over the years, say, with depreciation of infrastructure and new liabilities. However, we all know that on the stock market prices exhibit none of this stability or orderly gradated adjustment. Rather, they tend to bounce around erratically.
The reasons behind the stock market's erratic fluctuations must await another discussion. For the moment we are only concerned with the fundamental reasons underlying discrepancies between book and market capitalization, as well as their relevance to investment strategy.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
If this results in consumers willing to pay a brand premium for the product, capital otherwise hardly distinguishable from competitors effectively becomes more valuable. In such situations, obviously, there is no dispute about the literal book value of the company's assets. Nonetheless, though, further considerations may lead share traders to value the shares more than suggested by the 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.
Seeing the undervalued shares as a ticket to great profits they start bidding on them in great numbers, increasing demand for the shares and pushing up their price. The result is a market capitalization value greater than the book value.
The process of course can work the other way around, as well. Say the company is in a business whose industry faces new, onerous regulation, entailing major compliance costs. Those share traders who most quickly recognize the pending regulatory costs may perceive the book value of the company's liabilities as inaccurate. From their perspective, then, the shares could be regarded as overpriced, motivating them to unload them. Lowering prices to sell enables them to cut their losses.
As we've seen, then, numerous potential reasons may lie behind the discrepancy between book and market value. In all cases, though, this discrepancy reflects the judgment of a large-enough number of traders that the company's actual value is not accurately reflected in its book value. For the successful investor, early recognition of such a situation and sound assessment of its validity is the key to successful investment strategy, leveraging 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.
It is in this way that knowledge of the difference between book value and the market capitalization unlocks vital investment opportunities. If this discussion presumes knowledge about market capitalization with which you don't feel quite up to speed, I'd suggest having a look at 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.)
Book price is stable, though, if subject to sound accounting, it may change over the years, say, with depreciation of infrastructure and new liabilities. However, we all know that on the stock market prices exhibit none of this stability or orderly gradated adjustment. Rather, they tend to bounce around erratically.
The reasons behind the stock market's erratic fluctuations must await another discussion. For the moment we are only concerned with the fundamental reasons underlying discrepancies between book and market capitalization, as well as their relevance to investment strategy.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
If this results in consumers willing to pay a brand premium for the product, capital otherwise hardly distinguishable from competitors effectively becomes more valuable. In such situations, obviously, there is no dispute about the literal book value of the company's assets. Nonetheless, though, further considerations may lead share traders to value the shares more than suggested by the 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.
Seeing the undervalued shares as a ticket to great profits they start bidding on them in great numbers, increasing demand for the shares and pushing up their price. The result is a market capitalization value greater than the book value.
The process of course can work the other way around, as well. Say the company is in a business whose industry faces new, onerous regulation, entailing major compliance costs. Those share traders who most quickly recognize the pending regulatory costs may perceive the book value of the company's liabilities as inaccurate. From their perspective, then, the shares could be regarded as overpriced, motivating them to unload them. Lowering prices to sell enables them to cut their losses.
As we've seen, then, numerous potential reasons may lie behind the discrepancy between book and market value. In all cases, though, this discrepancy reflects the judgment of a large-enough number of traders that the company's actual value is not accurately reflected in its book value. For the successful investor, early recognition of such a situation and sound assessment of its validity is the key to successful investment strategy, leveraging 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.
It is in this way that knowledge of the difference between book value and the market capitalization unlocks vital investment opportunities. If this discussion presumes knowledge about market capitalization with which you don't feel quite up to speed, I'd suggest having a look at my What is Market Capitalization article.
About the Author:
Investors eager to leverage profits from misvalued book equity should be keeping up with the hottest scoop at the Market Capitalization site. Wallace Eddington is an insightful 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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