In order to accurately attribute a valuation on a company, those investing will take a careful look at the company’s balance sheet and market activity in order to anticipate risk related to making an investment in that company. These two values are key to investors trying to assess whether a company’s stock is undervalued, fairly valued, or overvalued.
Why Book Value and Market Value
The reason book and market values are used by investors during their evaluation is due to the distinction between the two. A company’s book value is what has happened in the past on a company’s balance sheet and the market value is what will happen in the company’s future.
When to Use Each
Generally accepted accounting principles (GAAP) dictate that hard assets (like brick-and-mortar buildings, technology, equipment, etc.) that are included on a company’s balance sheet should only be listed at their individual book value. Companies with assets that have appreciated a great deal cannot adjust the values of their assets to reflect this appreciation which would otherwise add to the overall value of the company. This may cause problems for companies counting on these assets as part of the company’s equity.
This is where the market value of a company comes into play. This value is figured based on the financial markets. Due to the appreciation of the company’s assets, the stock market may reflect investor confidence in a company’s revenue and therefore attribute a greater value to the company than shown on the balance sheet.
How to Determine Book Value vs. Market Value
In order to determine a company’s book value of a stock, the company’s liabilities are subtracted from the total assets of the company. That figure is the company’s equity—what the company is really worth. This book value is the numerical figure what would be paid to company shareholders in a liquidity event once all liabilities were paid.
The term “book value” comes from the fact that a company’s books, its balance sheet, contain a listing of the kinds of assets, as well as though liabilities, used to determine equity. Book value is denoted as the true worth of a company.
A company’s market value, on the other hand, is the projected worth of a company. Often, market value is seen as the highest estimated worth of the company’s stock. Market value is the current price at which the company can sell an asset on a competitive open stock.
When book value is greater than market value, it’s typically because investors are no longer confident in the value of the stock based on the capacity of the assets to generate future profits and cash flows.
While a company’s book value is different from its market value, both evaluations determine the company’s position from a financial perspective. By comparing the two values, investors can assess the value of the company’s stock and its potential for earnings growth.
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