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How to Correctly Use Stock Indicators
Part 4: Book Value
The most important criterion for evaluating stocks on the stock exchange is the profit of the respective company, as the basis for indicators such as P/E ratio. Stocks of companies that achieve high profits, are especially productive, or show strong growth dynamics are valued higher on the stock exchange.
In times of crisis, the substance comes into focus:
But what if companies do not make a profit or if the outlook for the company or the economy as a whole is very bleak? Then profit is hardly suitable as a measure for evaluating stocks. Especially after sharp declines in stock markets, such as in 2001 and 2008, or during economic recessions, the question comes to the forefront: What is the substance of the company? And: Is the stock price below the book value, making the stock worth buying?
What are the pitfalls of book value?
In broad terms, the book value roughly corresponds to a company’s equity. This seems simple. However, the book value is actually only an approximation for the substance value of a company (see on the right). For example, the company may have unreported assets such as a well-known company or product name, which could be sold separately in the event of a breakup. In addition, the reported values may not correspond to market prices. For example, in the event of a breakup, inventories may generate far less revenue than they represent in the balance sheet. As you can see, a detailed analysis is always necessary to determine the true substance value of a company. It is therefore no wonder that negotiations in the takeover of companies take so long and the price expectations often diverge significantly. When you divide the book value by the number of shares, you get the book value per share (analogous to earnings per share). The stock price divided by the book value per share then yields the price-to-book ratio (P/B ratio).
What is substance?
The substance value corresponds to the sum of all assets (assets) of a company, valued at market prices and reduced by the debts. It is the price that a potential buyer would be willing to pay if he were to break up the company and sell the assets (real estate, machinery, patents, etc.) individually. However, this also means that the company itself has no intrinsic value in that case, no corporate value (“goodwill”) is attributed. In normal circumstances, a company has the potential to generate profits and earn a return on equity. The value of a company is therefore usually higher than that of its individual parts.
Our conclusion:
In normal stock market times, the book value plays a subordinate role in the evaluation of stocks. However, in times of crisis and in the event of a takeover, this balance sheet ratio comes into focus. However, maintain a healthy skepticism towards the book value shown in the balance sheet, as extraordinary write-downs, for example, can quickly reduce it. In the next part of this series, we will address the price-to-book ratio (P/B ratio).
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