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'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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
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.
Other discrepancies may arise though from disputing the book value. Say a company has among its assets undeveloped land that the market, like the accountants, has valued in its equity calculation at the going real estate rates. However, should a large enough subset of share traders believe - for whatever reason - that the region in which this land is located is on the verge of a major real estate boom, they would consider the current asking price for the company's share to be undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than 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.
As seen in the examples above, there are a variety of skills and insights one might bring to bear in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Whatever your own edge, if you can recognize where the market valuing of a company's capitalization fails to adequately appreciate the true or immanent, as opposed to book, value of a company's assets, the opportunity for profitable investment - whether buying or selling - has presented itself.
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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
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.
Other discrepancies may arise though from disputing the book value. Say a company has among its assets undeveloped land that the market, like the accountants, has valued in its equity calculation at the going real estate rates. However, should a large enough subset of share traders believe - for whatever reason - that the region in which this land is located is on the verge of a major real estate boom, they would consider the current asking price for the company's share to be undervalued.
Such undervalued shares are tickets to windfall profits. Those traders convinced of the coming real estate boom thus seek to buy the shares in great numbers, increasing demand for the shares and bidding up their price. The result is a market capitalization value greater than 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.
As seen in the examples above, there are a variety of skills and insights one might bring to bear in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Whatever your own edge, if you can recognize where the market valuing of a company's capitalization fails to adequately appreciate the true or immanent, as opposed to book, value of a company's assets, the opportunity for profitable investment - whether buying or selling - has presented itself.
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 all the hottest tips at the Market Capitalization site. Wallace Eddington is an insightful 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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