Elsewhere, I have explained the difference between how book and market capitalization is calculated. There won't be space to repeat that explanation at length 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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
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.
So consumers will pay more for it; thus, due only to its brand, the capital to produce a Y is considered more valuable by the share traders. In this case the literal book value isn't disputed, but an additional consideration results in a market value greater than the book value.
Many discrepancies, however, are indeed a function of markets disagreeing with the stated book value of a company's assets. An example would be the situation in which a company's assets include undeveloped land. If the market, and the company's accountants, has valued the assets at prevailing real estate rates a potentially dramatic divergence of value could result if enough share traders re-evaluate the land. Say, for instance, they become convinced that the region in question is poised for a major real estate boom. At that point traders may now consider the land a significantly undervalued asset on the company's books.
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.
It can likewise work the other way around. If the company is in a business which a large enough number of share traders become convinced will soon be subject to new, onerous regulation that will entail massive compliance costs, their conclusions could be that the company's book value of its equity insufficiently accounts for its actual liabilities. The shares are considered overpriced and shareholders start lowering prices to unload them and 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.
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.)
The book value of the company will be a more stable price. However, if it is subject to sound accounting practices, it too will change with the passage of time. An obvious example would be in the case of the depreciation of infrastructure. Stock market prices, though, as we all know, do not reflect such stability or orderly gradated adjustment. Instead, they fluctuate - and often far and fast.
Discussion of this constant movement of stock prices will have to wait for another occasion. Here we only want to understand the reason for the discrepancies between book and market capitalization and the relevance of that difference to investing.
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.
So consumers will pay more for it; thus, due only to its brand, the capital to produce a Y is considered more valuable by the share traders. In this case the literal book value isn't disputed, but an additional consideration results in a market value greater than the book value.
Many discrepancies, however, are indeed a function of markets disagreeing with the stated book value of a company's assets. An example would be the situation in which a company's assets include undeveloped land. If the market, and the company's accountants, has valued the assets at prevailing real estate rates a potentially dramatic divergence of value could result if enough share traders re-evaluate the land. Say, for instance, they become convinced that the region in question is poised for a major real estate boom. At that point traders may now consider the land a significantly undervalued asset on the company's books.
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.
It can likewise work the other way around. If the company is in a business which a large enough number of share traders become convinced will soon be subject to new, onerous regulation that will entail massive compliance costs, their conclusions could be that the company's book value of its equity insufficiently accounts for its actual liabilities. The shares are considered overpriced and shareholders start lowering prices to unload them and 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.
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 benefit from misvalued book equity should be keeping up with the hottest scoop at the Market Capitalization site. Wallace Eddington is an insightful commentator on markets and finance. His recent article on fiat currency and inflation is a must read for those looking to make sound monetary investments.
No comments:
Post a Comment