The difference between book and market capitalization and how it is calculated is a matter I've addressed elsewhere. Space constraints prevent repeating the explanation at any length.
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.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
The reasons behind the stock market's erratic fluctuations must await another discussion. For the moment we are only concerned with the fundamental reasons underlying discrepancies between book and market capitalization, as well as their relevance to investment strategy.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
If this results in consumers willing to pay a brand premium for the product, capital otherwise hardly distinguishable from competitors effectively becomes more valuable. In such situations, obviously, there is no dispute about the literal book value of the company's assets. Nonetheless, though, further considerations may lead share traders to value the shares more than suggested by the book value.
Certainly, though, discrepancies can arise over disputation of a company's stated book value. For example, imagine a company with assets that include large tracks of undeveloped land. Let's say up to a certain point both the market and the accountants valued this asset at going real estate prices. Should it come to pass, though, that a large-enough group of share traders become convinced that the area in which the undeveloped land is situated is on the verge of a major real estate boom, such traders may regard the land and its assigned value in the book capitalization calculations quite differently. The company's shares may be perceived as significantly 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.
The process of course can work the other way around, as well. Say the company is in a business whose industry faces new, onerous regulation, entailing major compliance costs. Those share traders who most quickly recognize the pending regulatory costs may perceive the book value of the company's liabilities as inaccurate. From their perspective, then, the shares could be regarded as overpriced, motivating them to unload them. Lowering prices to sell enables them to cut 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.)
Relatively speaking, book value is stable. That, though, doesn't mean it will never change. An obvious example would be in the case of depreciating infrastructure: sound accounting practices would take such diminishing value into account. Everyone knows, though, that stock market prices are not prone to such stability or orderly gradated adjustments. They are more inclined to erratic fluctuations.
The reasons behind the stock market's erratic fluctuations must await another discussion. For the moment we are only concerned with the fundamental reasons underlying discrepancies between book and market capitalization, as well as their relevance to investment strategy.
Putting those reasons aside, just briefly, the basic principle involved is simply that the market - by which, of course, we mean the buyers and sellers of companies' shares, through constant bid-ask operations - hits upon prices disputing the equity value that the company assigns its own capitalization.
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.
If this results in consumers willing to pay a brand premium for the product, capital otherwise hardly distinguishable from competitors effectively becomes more valuable. In such situations, obviously, there is no dispute about the literal book value of the company's assets. Nonetheless, though, further considerations may lead share traders to value the shares more than suggested by the book value.
Certainly, though, discrepancies can arise over disputation of a company's stated book value. For example, imagine a company with assets that include large tracks of undeveloped land. Let's say up to a certain point both the market and the accountants valued this asset at going real estate prices. Should it come to pass, though, that a large-enough group of share traders become convinced that the area in which the undeveloped land is situated is on the verge of a major real estate boom, such traders may regard the land and its assigned value in the book capitalization calculations quite differently. The company's shares may be perceived as significantly 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.
The process of course can work the other way around, as well. Say the company is in a business whose industry faces new, onerous regulation, entailing major compliance costs. Those share traders who most quickly recognize the pending regulatory costs may perceive the book value of the company's liabilities as inaccurate. From their perspective, then, the shares could be regarded as overpriced, motivating them to unload them. Lowering prices to sell enables them to cut 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 who want to benefit from misvalued book equity need to follow the hottest scoop at the Market Capitalization blog. 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.
0 comments:
Post a Comment