In an earlier article, I elaborated on what distinguishes book and market capitalization. Space constraints do not permit a detailed reiteration of those points, here.
Suffice it for now to say that the book price is the value that a company's accountants and executives attach to its equity - derived by total liabilities subtracted from total assets. The market price is the valuation that traders in the company's shares arrive at through the market exchange process. (For more detail on how these numbers are derived, 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 difference may be of course either more or less than book value. The potential reasons for the discrepancy may be any of many. It can be as simple a matter as brand recognition and estimation. Should a particular brand have a high enough cache or reputation with the relevant consumer base, virtually identical products may be differently valued in the market, allowing the stronger brand to successfully charge more.
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.
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.
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.
There may be a great number of possible reasons for discrepancies between the book and market value of any company's capitalization. They always though indicate some ambivalence on the part of the market about the accuracy of the company's book value. Recognizing both the reason and the validity behind such ambivalence is essential for a sound investment strategy, leveraging market capitalization against book value.
The illustrations above provide plenty of different manners in which diverse skills and insights can aid in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Possessing insight into any of these matters, or numerous others, can provide the opportunity to benefit from a book value that inadequately appreciates the true or immanent value of a company's equity. When you discover such a discrepancy the opportunity for profitable investment - whether under or overvalued - is available.
Understanding the difference between book and market value, and the process of market capitalization, we can see then is immensely valuable for investors. If this all presumes knowledge about market capitalization with which you don't feel acquainted, I suggest you follow up with my What is Market Capitalization article.
Suffice it for now to say that the book price is the value that a company's accountants and executives attach to its equity - derived by total liabilities subtracted from total assets. The market price is the valuation that traders in the company's shares arrive at through the market exchange process. (For more detail on how these numbers are derived, 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 difference may be of course either more or less than book value. The potential reasons for the discrepancy may be any of many. It can be as simple a matter as brand recognition and estimation. Should a particular brand have a high enough cache or reputation with the relevant consumer base, virtually identical products may be differently valued in the market, allowing the stronger brand to successfully charge more.
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.
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.
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.
There may be a great number of possible reasons for discrepancies between the book and market value of any company's capitalization. They always though indicate some ambivalence on the part of the market about the accuracy of the company's book value. Recognizing both the reason and the validity behind such ambivalence is essential for a sound investment strategy, leveraging market capitalization against book value.
The illustrations above provide plenty of different manners in which diverse skills and insights can aid in such leveraging: e.g., familiarity with the real estate market, the government's legislative agenda or popular taste. Possessing insight into any of these matters, or numerous others, can provide the opportunity to benefit from a book value that inadequately appreciates the true or immanent value of a company's equity. When you discover such a discrepancy the opportunity for profitable investment - whether under or overvalued - is available.
Understanding the difference between book and market value, and the process of market capitalization, we can see then is immensely valuable for investors. If this all presumes knowledge about market capitalization with which you don't feel acquainted, I suggest you follow up with my What is Market Capitalization article.
About the Author:
Investors who want to leverage profits from misvalued book equity should be keeping up with the hottest scoop at the Market Capitalization site. Wallace Eddington is a widely published 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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