In the present times, it is essential for you to make your money work for you. To create wealth for your future while taking care of your present financial requirements, you must invest investment avenues with higher growth potential. Equity market offers that. You need to exercise a lot of discipline and conduct thorough research while taking an investment decision. And the research should include Book Value of the company.

What is Book Value?

Book Value is a term used to signify the total value of a company’s assets, i.e. book value of assets (after depreciation) minus book value of liabilities. Though it should ideally include every single asset of the company including small objects like stationeries, only significant assets are considered while calculating book value.

Companies lesser assets (like service industry) will have a lower book value, where it will hold little or no importance for investors. Companies with substantial physical assets such as those in manufacturing business or banking industry will have significant assets. As a result, their book value is going to be massive. While considering investment in stocks of such companies, book value is the most important figure for the investors.

The significance of Book Value while taking an investment decision

When you divide the current price of the share of a company with its book value per share, you get P/B (price to book value) ratio. P/B ratio serves as a highly useful comparison tool while taking an investment decision.

P/B Ratio less than 1.0 Stock of the company is undervalued
P/B Ratio above 1.0 Net worth of company shares is bloated
P/B Ratio is equal to 1.0 Company stocks valued at par

If the P/B ratio is less than 1.0:

If the P/B ratio is lower than 1.0, it means that the stock of the company is undervalued. It presents an excellent opportunity for value investors, who are always looking to add undervalued stocks to their portfolio. In practical terms, a P/B ratio of less than one means that if the company were to go bankrupt and goes into liquidation, the shareholders would make a profit on their investment even after all the liabilities of the company are settled.

If the P/B ratio is equal to 1.0:

If the P/B ratio is equal to 1.0, it means that the stock of the company is valued at par. This ratio signifies that market is indifferent as to if the company continues being in business or goes out of business. In this case, the investors do not stand to lose anything or make any profit, if the company is to go into liquidation. The wealth of the shareholders will remain unchanged after settling all the liabilities of the company. If the company continues doing business, the shareholders’ wealth might increase or decrease.

If P/B Ratio is more than 1.0:

If the P/B ratio is more than 1.0, it signifies that the net worth of the company is bloated. Here, investors stand to lose their money if the company goes into liquidation. Though the company may be more valuable if it continues doing business but from an investors point of view, investing in shares of such a company is not advisable. If the P/B ratio is below 1.0, the shareholders can vote to liquidate the company to minimize their losses

Cautions to be taken while using Book value to take investment decisions

There are certain situations where you need to be cautious while using book value as the sole criterion for taking investment decisions. Some situations that you must be careful of are:

  • Book Value of companies engaged in the service industry or labor-intensive industry might be lower. Here, you can not take a decision based on book value alone.
  • Some companies tend to fudge the value of their assets to improve their book value. You must study the financial reports of the company carefully before deciding to invest.
  • Usually, contingent liabilities are not considered while estimating the book value. You must carefully study the financial reports for such information.
  • Some companies follow conservative depreciation methodology which is not in sync with the market trend. Do keep an eye on it.

Therefore, using book value to take an investment decision related to an asset-driven company is a wise approach, but it comes with its caveats. You, therefore, need to study the financial reports carefully before coming to a final decision regarding the investment decision.

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