This post is just to clear the confusion over my earlier explanation of Book Value in this thread:

Significance of Equity of a Company.

This may seem confusing if you look at the balance sheet of a company.

In every balance sheet, assets are balanced by liabilities.

i.e. Assets = Liabilities.

However, that doesn't mean the book value of every company is zero.

Actually, "assets" in a balance sheet are the applications of funds and "liabilities" are the sources of funds.

As a company's equity is also a source of fund, it is mentioned in the "liabilities" side of the balance sheet.

The funds that make up equity of a company are either the share capital or the reserves (retained profits).

If you have the balance sheet of a company, it is simple to calculate the book value.

Just add up the share capital and reserves and then divide by the number of shares outstanding.

Suppose I want to calculate the book value of Pratibha Industries at the end of FY 2009.

I look at the balance sheet:

http://www.moneycontrol.com/financia...nce-sheet/PI33

Networth of the company at the end of FY 2009 was 224.73 crore.

(Networth is equity of the company).

Number of shares outstanding for Pratibha Industries at the end of FY 2009

= 16685000

Therefore book value of Pratibha Industries

= 2247300000 / 16685000 = 134.69.

You can verify it here:

http://www.moneycontrol.com/india/st...ndustries/PI33

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Nice! Great help to see how the numbers are put together for someone unfamiliar with much of the terms used.

great explanation once again Alchemist sir.
I found this by googling:


What is preferred equity?
Also how does the book value affect the stock price?

"Preferred equity" are the "Preference shares" issued by the company.

Preference shares are called "shares" but their characteristics are more like debt.

-they have a fixed dividend, which has to paid before any dividends are paid to common stock holders.

-in case the company is liquidated, preference shareholders have the first right to assets of the company.

==============================

"Book Value" doesn't really affect the stock price, but many analysts look at the "Price to Book Ratio" to determine if the stock is undervalued or overvalued.

Book Value is essentially the amount of money that shareholders have invested in a company, in the form of initial capital and retained profits.

If this money is invested in poorly performing assets, the ROE of the company will be poor too.

In such cases, the price of the stock falls below the book value.

An asset may have been created by investing Rs 100, but if the returns generated by the asset are only Rs 1 or Rs 2 per year, the asset isn't worth the original investment and should trade below its "book value".

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Please find the Balance Sheet for ICICI Bank. Please explain the following two points ?

ICICI Bank - Balance Sheet

1) What is the role of Contingent Liabilities ? Does this figure has a role to play while ascertaining book value ?

2) In case of a company going bankrupt, can book value be regarded as the fair liquidation value of the shares of the company ?

Book Value is Overvalued



Every few days, somebody comes and asks me:

"Stock ABC is trading below book value. Should I buy it? ".

In my opinion, book value is the most overvalued tool for stock analysis.

Buying a stock just because it is trading below its book value makes no sense.

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1. Book value is a historical figure.

Book value basically comprises of shareholders' original capital and the retained earnings of the company.

Companies are not valued by their past performance, but by their future prospects.

Then why should an investor look at the book value, which is nothing but a historical accounting figure?

Just because an asset was created by an investment of Rs 100, doesn't mean the asset is worth Rs 100 today.

The value of an asset comes from the current earnings and future earnings.

The earnings potential of an asset is much more important than the historical cost of the asset.

Book value is nothing but the historical cost of the company's assets. (Book value is adjusted for depreciation, impairment etc, but still is a historical value).

2. Book value may be overstated.

For companies that are manipulating their financial statements, the book value figure is totally useless.

As I said earlier, one of the components of the book value is retained earnings. If earnings of the company are overstated, the book value will be overstated too.

3. Book value may be a good indicator of overvaluation.

I don't think book value is a good indicator for undervaluation, but it can be a good indicator of overvaluation.

Lets say a stock has a book value of Rs 100 and is trading at Rs 1000.

What does that book value of Rs 100 indicate?

It indicates that the shareholders have contributed Rs 100/share to the company in the form of share capital and retained earnings.

This Rs 100/share was used to create some assets for the company.

and for these same assets, the market is now paying Rs 1000/share.

The question that the investor should ask is:

"Have the assets created by the company with an investment of Rs 100/share become so profitable that the investor should be paying Rs 1000 for them?"

If the investor feels the answer to the above question is "No", the stock should be avoided.

4. In some cases book value may be understating the real worth of the company.

Value of certain types of assets like land may be understated in books of a company.

A piece of land bought for Rs 5 crore a few years back may be worth Rs 50 crore now.

Thus, a high P/BV ratio doesn't always mean overvaluation.

5. Companies with high dividend payout ratios may trade at high P/BV ratio.

If a company is not retaining its earnings, then its book value will not increase.

This can happen with companies which don't need to create many assets to run their respective businesses.

If the earnings potential for the company keeps increasing, investors will be ready to pay a high price for the stock. In such cases the P/BV ratio may look abnormally high.

6. Banking is one a sector where P/BV ratio is relevant.

In the banking sector, most of the assets/liabilities are financial in nature and these assets/liabilities are adjusted for MTM changes etc.

Also, interest costs/incomes of these liabilities/assets are similar across all banks.

This makes book value a much more reliable indicator for banks than for other companies where assets and liabilities vary a lot.

7. Low "Price to Book Value" may mean trouble ahead.

Suppose a company ABC created a manufacturing capacity using Rs 100 crore.

The company initially expected to make Rs 15 crore of annual PAT from this capacity.

However, when the new capacity was commissioned, a cheaper and better product came into the market.

This new product almost killed the demand for product of ABC.

The future PAT for the company may not be more than Rs 1 crore.

This asset has an accounting book value of Rs 100 crore.

but will an investor value this asset at Rs 100 crore?

Obviously no.

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As I said earlier,

A asset is as good as the financial returns that it is giving (and can give in the future).

An asset cannot be valued at its original cost.

(An asset may be valued at the price that it will fetch on liquidation of the company, but that doesn't happen with most companies. We have to value companies as a "going concern").

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If a company is trading below its book value, then it can be a warning sign too.

a) It may mean the future prospects of the company are not good. The assets created by the company are expected to generate low returns compared to their original cost.

or

b) It may also mean that the investors think the financial statements of the company are falsified and cannot be trusted.

This doesn't mean that all stocks trading below book value are bad investments.

All I am saying is when you find a stock that is trading below book value, ask yourself if the company deserves to trade below book value?

Is either a) or b) is applicable?

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Another great cautionary explanation.

Alchemist, perhaps one of the reasons why book value was more important in the days gone by (Graham's era) was that companies (excluding financial), by and large, owned assets that were tangible.

Nowadays, with information presumably being disseminated so rapidly and markets valuing things like branding and other intangibles, it may be more difficult to find genuine "value" stocks as determined by the P/BV metric.

See this thread on Contingent Liabilities.

Companies file for bankruptcy when the management feels the total liabilities of the company exceed the total assets of the company.

Usually in such a case, the shareholders are left with nothing.

Filing for bankruptcy is always the last option.

A firm in financial trouble will first try to sell its assets, reorganize debt, issue new equity etc.

Only when everything else fails, a company files for bankruptcy.

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In US, Chapter 11 bankruptcy allows businesses to restructure.

Chapter 11 doesn't mean liquidation of the entire business.

Chapter 7 is the one that leads to total liquidation.

Source:

http://www.investopedia.com/ask/answers/190.asp

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Thus, if a company is filing for bankruptcy, an investor should assume that the networth of the company has been wiped out, even if the financial statements are showing a positive value.

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Even if a company is voluntarily liquidating, liquidation values are never equal to the book value of the assets.

Liquidation value can be higher or lower than the book value - depending on the type of assets that the company has.

An asset like land may get sold at a price higher than its book value.

An asset like a PC may have near-zero book value because of high depreciation rates, but it still may fetch a good price.

A asset may have some book value, but may be obsolete because of new technology in the market.

Such an asset won't fetch a price anywhere close to its book value and may get sold as scrap.

If a liquidation is carried out in a "fire sale" way, even good quality assets may get sold at a fraction of their book values.

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