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How Book Value and ROE are Intertwined

By Jordan Wathen and Gaby Lapera – Mar 12, 2016 at 11:40AM

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Here’s how to use book value and return on equity in evaluating a stock.

Book value and return on equity are two measures that are highly useful to understanding the value and profitability of all companies, but especially financial companies. These simple measures are easy to calculate, and can be further modified to make better sense of the performance of individual companies.

In this week's Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss how investors can make use of financial ratios to better understand the stocks they own in their portfolios.

A transcript follows the video.

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This podcast was recorded on March 7, 2016. 

Gaby Lapera: Jordan, do you want to go ahead and start talking about book value per share?

Jordan Wathen: Sure. So, when you think about book value, book value is essentially shareholders' equity. And you get to shareholders' equity by looking at the balance sheet. You look at assets and you subtract the liabilities from the assets to get to shareholders' equity. And then, from there, of course, you divide shareholders' equity by the number of shares to get your book value per share. 

And this is a really valuable thing to understand. Essentially, what shareholders own of a company, once all the liabilities, the bondholders, the people who have given you inventories, for example, on credit, once they're paid off, what do shareholders have left over for them? And so, understanding that value on a per-share basis can really help you understand the value that underlies an individual share you might own. So, if you own 100 shares, and you can know what the book value per share is, you know, basically, the net value of those shares for accounting purposes.

Lapera: I have a question for you. What about intangible book value?

Wathen: Intangible book value, especially -- this is a financials show, so with banks, it's an important one. Intangible book value, especially for banks, is usually goodwill. So, it's the value that exceeds the tangible value of assets from an acquisition. So, if a bank buys another bank, they're not just going to pay 1x equity. They'll usually pay something like 1.5x equity, and the extra 0.5x equity has to be applied to an asset after an acquisition. And usually, that's ascribed to goodwill, which is basically the value of customer relationships, the value of the brand, things that necessarily couldn't be sold, if you had to sell them.

Lapera: Right, it's not a printer. It's more of a feeling.

Wathen: Right, it's something that doesn't really exist, but it does. It's hard to explain. (laughs) 

Lapera: Yeah, absolutely. But it still factors in to book value per share, so it's just something you kind of want to keep in mind. You could, of course, do tangible book value per share. And tangible, of course, means things you can touch. So, it's literally the assets the company has, excluding any sort of goodwill that might be factored into the books.

Wathen: Right. When people look at banks, they usually like to look at tangible book value because it gives you a very good understanding of what the actual real liquidation value of a bank is. Also, when you're measuring return on equity, which we're going to get to, if you measure return on tangible equity, that's kind of like a measure of how fast a bank could grow organically, instead of acquisitively.

Lapera: Okay. You kind of teed yourself up there, do you want to talk about return on equity now?

Wathen: So, return on equity, once you've calculated book value -- so, you take your assets, you subtract liabilities, now you have your book value. Return on equity is, you take the company's net income, then you divide it by the book value. So, if a company makes $100 million on a book value of $1 billion, the return on equity for this company would be 10%.

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