Elsewhere, I have explained the difference between how book and market capitalization is calculated. There won't be space to repeat that explanation at length here.
It will have to be sufficient to explain that book value references the determination of a company's accountants and executives about the value of its equity: liabilities subtracted from assets. In contrast, markets distill prices for the value of the company, arrived at by share traders, in their exchanges. (To understand the basics in greater detail, see the link at the bottom 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.
What lies behind such erratic fluctuations will have to be discussed at another occasion. For present purposes, it is the reasons for the discrepancies between book and market capitalization and their relevance to investing which are of concern.
Putting the reasons aside just for the moment, the most basic explanation is that the market - i.e., those who buy and sell companies' shares, via their bid-ask interactions - arrive at prices with different valuations of a company's equity than that of the company itself.
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.
Since consumers demonstrate their willingness to pay a brand premium, share traders way conclude that the very same capital at the company with the preferred brand is more valuable than at the company with the lesser brand. The literal book value is not disputed in this case. Additional considerations, though, lead the market to value the more popular brand in excess of formal 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.
Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company's shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over the book value.
Naturally, of course, the process can unfold in the opposite direction. If the company in question works in an industry where new, onerous regulatory compliance costs will cut into profitability, those who foresee these developments far-enough in advance will recognize the book value of the company's liabilities as understated. The shares are determined to be overpriced. As a result, shareholders may lower their asking prices in hopes of unloading the overpriced shares and cutting 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 will have to be sufficient to explain that book value references the determination of a company's accountants and executives about the value of its equity: liabilities subtracted from assets. In contrast, markets distill prices for the value of the company, arrived at by share traders, in their exchanges. (To understand the basics in greater detail, see the link at the bottom 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.
What lies behind such erratic fluctuations will have to be discussed at another occasion. For present purposes, it is the reasons for the discrepancies between book and market capitalization and their relevance to investing which are of concern.
Putting the reasons aside just for the moment, the most basic explanation is that the market - i.e., those who buy and sell companies' shares, via their bid-ask interactions - arrive at prices with different valuations of a company's equity than that of the company itself.
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.
Since consumers demonstrate their willingness to pay a brand premium, share traders way conclude that the very same capital at the company with the preferred brand is more valuable than at the company with the lesser brand. The literal book value is not disputed in this case. Additional considerations, though, lead the market to value the more popular brand in excess of formal 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.
Recognizing such undervalued shares sufficiently in advance is a means to great profits. Those who have early enough recognized the situation bid on the company's shares in great numbers. The more shares one can purchase at the undervalued price the more total profit one stands to make whether the long term intent is to resell at the higher price or collect the increased dividends expected. In the process, of course, this raised demand for the shares pushes up their price. The resulting market capitalization value is thus increased considerably over the book value.
Naturally, of course, the process can unfold in the opposite direction. If the company in question works in an industry where new, onerous regulatory compliance costs will cut into profitability, those who foresee these developments far-enough in advance will recognize the book value of the company's liabilities as understated. The shares are determined to be overpriced. As a result, shareholders may lower their asking prices in hopes of unloading the overpriced shares and cutting 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 benefit from mistakenly valued book equity need to follow all the hottest tips at the Market Capitalization site. Wallace Eddington is a widely published commentator on markets and finance. His recent piece on fiat currency and inflation is a must read for those looking to make sound monetary investments.
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