IF YOU OPEN a company’s annual report and turn to the page showing its balance sheet, you’ll see something called stockholder’s equity, which is the value of the company’s assets minus its liabilities. Stockholder’s equity reflects the amount investors have put into the company through stock offerings and reinvested earnings—and how much they might receive if the company were liquidated and all liabilities paid off.
Investors will sometimes take stockholder’s equity, figure out this “book value” on a per-share basis, and then compare it to the current stock price. A stock might be considered undervalued if it trades below book value and overvalued if it trades well above.
But this can be overly simplistic. All book value tells you is how much a company paid for its assets, minus the depreciation required by accounting standards, with no adjustment for subsequent inflation. If a company has to write down the value of some of its assets, that can take a big chunk out of book value—and make its shares seem overvalued based on price-to-book value. Similarly, if a company repurchases its own shares, it can shrink book value, making its stock price appear more expensive based on price-to-book value. There’s been a sharp increase in stock buybacks since 1982, when legal restrictions on repurchases were loosened, and that’s made price-to-book less effective in identifying undervalued stocks.
On top of all this, if a company has intangible assets such as brand names and patents, these may not be listed at full value on the asset side of the ledger, and thus they won’t be fully reflected in stockholder’s equity. Based on price-to-book value, certain companies—such as banks and insurers—look consistently cheap, while technology companies often appear expensive.
Despite its flaws, price-to-book value remains a popular yardstick, especially among value investors. While price-earnings ratios based on recent or expected earnings can sometimes be misleading, book value often provides a steadier gauge of a company’s value.
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