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Book Value explained and why is it essential for financial sector stocks

21 Sep 2022 0 COMMENT

Introduction

There are different ways to determine the value of stocks. Market value refers to the price investors are willing to pay to own a stock. Book value can be considered a stock’s net asset value. Many well-known investors use book value to estimate a stocks fair price which eventually helps them in their investment decision making.

What is Book Value? 

Book value is the value that its shareholders would receive in the event of liquidation of a company. It is the company’s value as reflected in its financial books of accounts. 

A company’s book value can be determined by subtracting the cost of its liabilities from the value of its assets. That is the value the company would get in the market upon liquidation if it were to sell all of its assets and settle its liabilities.

Book Value of a Stock = (Total Assets – Total Liabilities) / Total No. of stocks

Total assets include different financial assets, such as property, plant and equipment, inventory, total receivables, short-term and long-term investments, and cash, etc. Total liabilities entail short-term and long-term debt, accounts payable, and any taxes due. 

Let’s understand the book value of a company by using an example. Assume ABC’s total assets are worth Rs. 10 crore. This includes both its physical and intangible assets. Its liabilities of Rs. 7 crore include accounts payable and outstanding debt. Therefore, the company’s book value is equal to the difference between the total assets and total liabilities, which is Rs. 3 crore. This divided by the number of outstanding shares gives the book value per share.

Why is Book Value useful for valuation?

One of the most significant advantages of using book value to ascertain the value of a stock is that there is no room for subjectivity. You get the exact value of the company’s assets and liabilities instead of a perceived market value.

The market could overvalue or undervalue a company based on several factors. However, a company’s book value gives you a realistic picture—including the actual value of the assets after depreciation and the company’s total outstanding dues.

Value investors often use book value to look for stocks trading at bargain prices. If a stock trades below its book value, they consider it an excellent opportunity to buy. However, one thing to be wary of is whether the asset values are artificially inflated. This is a possibility and something to keep an eye out for when considering a company’s book value. 

Why is Book Value used for financial sector stocks?

Book value is especially a common metric when valuing financial sector stocks. Instead of calculating the price-to-earnings ratio, investors often prefer the price-to-book value ratio while understanding the value of a financial stock, such as banks.

One of the primary reasons the price-to-book value is considered for financial stocks and banks is to understand how their assets are used. For a bank or any other financial company, macroeconomic factors, such as inflation, interest rate, and liquidity, are more or less similar. What sets one bank apart from another is how efficiently it utilises its funds and manages its spreads and credit quality. Book value helps ascertain this with clarity.

Moreover, if a company is in a loss, ratio like a Price to Earnings (P/E) ratio doesn’t give any meaningful insight about the stock. In such scenarios, the book value is a lot more effective in understanding the efficiency of the company.

Takeaway

Book value can be beneficial to understanding a company’s value, especially financial sector stocks. It can be employed in many different metrics. However, for optimal understanding, one must consider different financial metrics and compare them over a period of time to get a holistic understanding of a company’s valuation.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.