Book value vs market value

N. R. Parasuraman

EQUITY shareholders of a company study its balance-sheet and profit and loss account not only for ascertaining the current profits and liquidity, but also for finding out the value of their investment. When one talks of `value’ of the investment. what is meant is the worth of the own funds of the company from various angles. Own funds are the amounts deployed by the shareholders as well as funds belonging to the shareholders used by the company for its business operations.

The book value of the shares of a company refers to the value of own funds for each share of the company. There are two broad approaches to finding out of this book value. These stem from the two approaches followed for determining the net worth of the c ompany.

Determining the net worth and book value:

Under Approach I, the assets side is totalled and `secured and unsecured loans’ deducted from the liabilities side. That leaves us with share capital and reserves, the total of which constitutes net worth.

Under Approach II, the share capital and reserves are totalled to arrive at the net worth.

By dividing the net worth with the number of shares outstanding, the book value per share is got.

Net worth refers to the value of the own funds of a company. The conventional approach to finding out net worth would be to deduct all external liabilities from the total assets. The total assets belonging to the company after depreciation and depletion represents in entirety what the company employs for the business operations. From this, if what the company owes to outsiders is deducted, what is left for the stakeholders is known. Alternatively, net worth can be taken as the total of the equity capita l and reserves of a company. Reserves also belong to the equity holders and along with the paid-up capital of the shares taken up by them, give the value of the total amounts belonging to them that is with the company.

The book value shows us what the shareholders’ stake is worth. Assuming that the company had made an initial public offering at par of Rs 10 per share, and the present book value is Rs 24 per share, it means that the investment by the shareholders has `a ppreciated’ to the extent of Rs 14 per share.

What is the justification behind adding reserves to the shareholders’ capital for computing net worth? Reserves are profits of the company, which belong to the shareholders. However, the company has decided to plough back the amount into the business. P ut differently, it is similar to a situation when the shareholders in their totality get the amount from the company and invest it back in the company. So, although no dividend has been declared, the amount still belongs to the body of shareholders.

The same justification holds when the company decides to revalue its assets and a capital reserve is formed for the appreciation in the value of the assets. Here again, the increase in the value belongs to the shareholders and although there may be legal and practical difficulties in realising the amount straightaway, the fact remains that the corpus does belong to the shareholders.

Market value

The market value of a company’s share refers to the price that is quoted in a recognised stock exchange that deals with the shares of the company. As per the regulations governing securities, it is possible for companies to list their shares in one or mo re stock exchanges. Once the listing is done, the shares become available for buying and selling at the exchange. The purchase and sale rates are determined by a number of factors, such as the profitability of the company, its profit potential, the numbe r of shares outstanding, general market fancy for such shares, and certain other intangible factors broadly called the `market sentiment’. The market price of the shares indicate the price at which the shares of the company can be bought or sold.

Can market value be more than the book value? Yes, the market value can be more than the book value. Market value is determined by the combination of all players in the market. This includes financial institutions, mutual funds, foreign institutional inv estors, securities operators and the common investor. Since the market price is the culmination of the demand and supply position in the market, one can conclude that the expectations of the various players will get reflected in it. So much so, the marke t value is the net result of the perception regarding current earnings, future earnings, industrial growth, competitive advantage, and so on. The book value of the shares would also be a factor that is taken into account by the market in arriving at the price, but it is just another factor.

Therefore, it is possible for the market price to be more than the book value if the net perception in the market is that the company has growth potential and that it is likely to perform better than it is doing at present.

Can book value exceed the market value? Why not? Sometimes, a company may be performing steadily and having a fair book value. However, because of the stagnation of growth possibilities or the imminent force of competition or other factors affecting its future chances, the market might have viewed the share in poor light. If so, we can have instances where the market value is less than the book value.

It will be interesting at this point to look at another allied concept _ earnings per share (EPS). The total post-tax earnings of the company divided by the number of shares outstanding gives us the EPS. This measure is used to understand how much the c ompany is making in respect of each of its shares. The higher the EPS, the better.

From the EPS, one can arrive at what is commonly called the price-earnings ratio (P/E multiple). The price that a company’s share commands can be studied in relation to the earnings of the company. The market value of the shares divided by the EPS gives us the P/E multiple of the share. Although there is no hard and fast rule as to the range of this measure, it is nevertheless useful to know the number of times that the market has multiplied its earnings. Of course, it must be noted that EPS and P/E mul tiple are only two of the several factors considered by the market in arriving at the price.

The book value of the shares of a company is the net figure arrived at by duly consolidating the individual book value of various items in the balance-sheet. It follows that if certain assets are valued higher in the balance-sheet, the book value of the company itself will go up. As a sample, we discuss the broad thinking framework in respect of valuation of inventories and intangibles.

Inventories relate to the stock of raw materials, work-in-process and finished goods with the company. The age-old canon is to value these at cost or market value, whichever is lower. However, certain companies follow some utilisation-based methods of ac counting these and consequently, the valuation of closing inventory can be higher or lower relative to the market value. As seen already, companies are required to follow uniform policies for accounting these items and, over a period of time, temporary a nomalies will be sorted out.

A tricky question of valuation will come up when we revalue the assets of the company or go in for valuing intangibles such as goodwill, brands, trademarks, and so on. Here, the higher the valuation of the base assets, the higher the book value of the co mpany itself. The company should be governed by the canon of objectivity and the valuation exercise should be undertaken by unbiased professionals to yield reasonably accurate results.

The figures in respect of four prominent companies, showing their book value as on March 31, 1999, and the market value range for trades over the last one year.

It can be seen that the book values and the market values have no discernible correlation at all. As stated, market value is determined on the principle of `outlook’, whereas book value is the result of `historical’ analysis.

One practical use of the above analysis will arise when a company plans to go in for a public issue for raising additional capital. The determination of the share premium to be charged from the investors has been left entirely to the company under the ex tant capital issues regulations. The lead managers to the issue will determine this for the company, by taking into account the book value and the future potential. From the investor’s angle, the share premium along with the par value will be what he pay s for the shares.

Recently, lots of studies have been made and new parameters have been devised to suitably reflect under simple measures the net worth, on the one hand, and the market value, on the other. The concept of market value added and economic value added are mea sures in this direction.

Concept check

* Over the last three years, the book value of a company has been consistently showing a value that is 25 per cent more than the market value. Does it indicate that the market value will soon catch up?

* Should the share premium charged by a company be less than its present book value?

* Can we have a situation where the EPS is very low, whereas the book value per share is almost four times the par value of the shares?