The first thing beginning investors learn is that there's a difference between what a company's shares are truly worth and what their current market price happens to be. But as useful as it is to know that, it still leaves the obvious question: How do you figure out the intrinsic value of a company?
As it turns out, you can find one answer to that question with almost no effort at all. By looking solely at a company's financial statements, it's easy to gauge one useful measure of its worth. And by that measure, some stocks look more expensive than they actually are, while others aren't as cheap as they look.
Understanding book value
If you asked someone who didn't know anything about finance how much a company was worth, you'd probably get a pretty simple answer:
- What does the company own, and how much are those things worth?
- How much does the company owe?
- Look at whatever the difference is. That's how much the company should be worth.
That, in a nutshell, is the idea behind book value. The book value of a company is the value of the company's assets less the amount of its liabilities. Whatever's left presumably represents shareholder value, and that's what book value seeks to measure.
Compared with other methods of putting a value on shares, book value has some definite advantages. Many beginning investors prefer to rely solely on earnings-based valuation models. But because earnings are volatile and easy to manipulate using various accounting methods, looking only at price-to-earnings ratios can give you a distorted view of a company's value.
When book value tells a different story
That said, book value certainly isn't immune from accounting trickery. The challenge in applying book value is that what you'll find on a balance sheet doesn't always reflect the actual current value of an asset.
For instance, consider Ford
Similar problems occur for companies that rely on intangibles to generate revenue. Whether it's software companies such as Microsoft
The other side of the coin
At the same time, some stocks trade at low multiples to book value. Yet that doesn't automatically make them good values. For instance, right now, you'll find a wide range of financial stocks, including Hartford Financial
But the big question for investors in stocks with low price-to-book ratios is how trustworthy those book values really are. With concerns about so-called toxic assets and uncertainties about whether they're truly worth what the books show as their values, the threat of asset writedowns continues to plague some financial institutions. If a writedown occurs, then it can send price-to-book ratios soaring even if the stock price ends up falling.
One tool for your toolbox
Despite its limitations, book value is still a useful way to look at a stock. By itself, it can be just as misleading as P/E or any other indicator that looks only at a single measure of value. But as part of your integrated investing toolbox, book value is something you can use as a second check on other valuation methods. Look at book value, and sometimes, what you see will help you avoid making a huge mistake.
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Fool contributor Dan Caplinger likes a bargain, but he doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Microsoft and Ford. Motley Fool newsletter services have recommended buying shares of Ford, GM, and Microsoft, as well as creating a diagonal call position on Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you the best info at the right price: free.