Book value of non-financial companies does not represent accurately the true value of the business. This is because, the value of asset recorded in companies balance sheet is done as per accounting rule. The accounting rule ask the accountant to value an asset like this: Cost of accusation minus depreciation.
There is a big chance that the valuation of land, factory’s, buildings etc which are recorded in balance sheet remains understated.
But assets of financial companies like banks and insurance companies are recorded as per their existing worth. Hence book value of financial companies are closer to companies true value.
Having said that, I will like to repeat this again; irrespective of the fact that book value of non-financial companies are not very accurate, but using book value for market price valuation of stocks is still one the essential check that must be done.
How to know book value of a company?
One shall read balance sheet of the company to know its book value.
Net worth of company is same as its book value.
In order to calculate net worth (book value) of a company we need to find a sum of equity capital & accumulated reserves. Companies equity capital and accumulated reserves figures are shown in companies balance sheets.
Book value (net worth) of company is one of the most quoted financial data of companies. Dividing net worth of company by number of shares outstanding in the market will give us book value per share.
Market price of a stock gives us per share valuation of that company valued by the market. But market generally do not value the companies accurately.
Hence, in order to judge if a stock is correctly valued or not, experts compare market price with its book value per share.
Book value is alternatively also called as shareholders equity.
We all know that common shareholders have a voting right in a company. Hypothetically speaking, if common shareholders forms a majority and decide to sell off a business, they can do it.
If the company is valued well by the market, the potential money that common shareholders will make, can be very good.
Lets take an example of few Indian companies which is currently trading at high P/B multiples. These companies can be called as ones which is valued well by the market.
Once the company is sold, the generated funds shall first be used to pay the outstanding debts/account payables.
Then the funds should be used compensate the preferential shareholders. After paying preferential shareholders, what is balance can be distributed among common shareholders on basis of the proportion of their shareholdings.
Frankly speaking, no body can say how much will be the portion of common shareholders. But minimum amount that each stock of shareholders may fetch is equal to one book value per share.
This is the reason why, as book value per share of a stock increases, its market price proportionately jumps. This is what makes book value per share so important for investors.
What are Accumulated Reserves?
Accumulated reserves finds its mention on companies balance sheets. Accumulated reserves is nothing but that portion of profit (PAT) that has been retained by the company (not paid as dividends).
The accumulated reserves depicted in balance sheet is the cumulative retained earnings of company over a period of time.
Generally in all public listed companies, shareholders have rights to earn a share in the net profits of the company. This profit sharing, if done, is paid to shareholders as dividends.
But if board of directors of company decides to retain these profits, they can do it. They have the right of not paying even $1 as dividends to shareholders. If this is done, all net profit (PAT) is transferred to companies balance sheets. This is reflected in balance sheet as increase in “reserves and surplus”.
So how does increase in “reserves and surplus” helps?
First of all, it helps both the company and the shareholders. It helps the company directly and it helps the shareholders indirectly. How?
Companies need funds to expand & modernize their existing operations. They avail debts to meet this requirement. They would not have resorted to debt financing if they had money in their kitty.
What is companies kitty? Companies kitty is their “reserves and surplus”. The higher is the companies reserves and surplus, less the company will be dependent on market debt.
But why debt is not preferable? Debt comes at a huge cost (interest burden for company). The company which has high debt will show lower PAT in their P&L Accounts.
But there are companies in India which has zero debt burdens. These are those companies which has a huge “reserves and surplus”. In other words, they have a proportionately very large book value.
It means, board of directors of a company would always like to keep increasing their book value year after year at a fast rate, right? Yes, so why they should care to pay dividends to shareholders?
This is a balance they have to maintain. To keep increasing the book value fast enough, and also keep shareholders interested in their stocks, is a challenge.
In case board of directors decide to share profit, the same is distributed in form of dividends.
Generally, not all profit is shared as dividends. PAT minus dividend paid to shareholders is transferred to balance sheet as reserves.
Technically shareholders of a company are owner of this accumulated reserves. This is one reason why accumulated reserves is part of shareholders equity.
How Investors can use book value per share for investing?
Suppose a company X has book value per share as Rs.1 in year 2003. By year 2013 its book value has appreciated to Rs.6. In terms of compounded annualized growth rate (CAGR), the companies net worth has increased at rate of 20% per annum in these 10 years.
Generally the market price of shares grows in a similar rate as its book value per share.
With this we can safely assume that if a investor had bought this stock in year 2003, by year 2013, his annualized return would had been close to 20% per annum.
But here I would like to caution my readers that it is important to buy stock at correct valuation. If the investor would had bought the stock at overvalued levels in year 2003, no matter how if the book value per share has grown at 20% per annum, actual return would have been considerably lower.
As a rule of thumb, by correct valuation I means, market price equal to 1.5 times its book value. This is called as price to book value ratio (P/B).
One must try to buy stocks at lower P/B value ratio. These days good shares are hard to get at P/B multiple of 1.5. Hence it is advisable to compare similar stocks (of same sector) to check if the stock in consideration is trading at high or low P/B multiples.
Example: One day I was studying an Indian stock names “Indraprastha Gas (IGL)”. I found that its P/B ratio is 5.57. This was too high. Hence I decided to compare IGL stock with its competitors. The result was as below:
Upon comparison, I found that one more stock named Petronet LNG was also trading at P/B multiple of 5+. But apart from this other oil exploration giants like ONGC, GAIL & Oil India was trading at very humble P/B multiples.
This gave a decent first hand realization about IGL that, it may be trading at very overvalued price levels. Hence while doing further drilling about IGL, I took extra care.
Market Price of all type of companies are sensitive to Book Value per share?
There are few selected sectors whose companies stocks are sensitive to its book value per share. While buying stocks of companies of these sectors, one shall consider evaluating P/B ratio. These companies has strong prospects of future market price appreciation with improvement in its book value per share.
(1) Big Blue Chip companies that has their own real estate property (in large numbers) to run its operations. Over a period of time the valuations of the real estate is only going to go up irrespective of the depreciation effect. Take example of Mcdonalds whose business though is selling foods/ snacks but the volume of real estate property it own across the world is outstanding.
(2) The companies which has operations in other countries also has prospects of increasing the valuations of book value over time. The growth prospects may be better in other operating countries.
Examples of how to study Book Value Per Share
#1. Castrol India
Castrol India’s book value per share for the year ending dec’2016 was Rs12.05.
During last 12 months, Castrol India’s average book value per share growth rate was 3.49% per annum.
During last 3 years, Castrol India’s average book value per share growth rate was 6.26% per annum.
During last 5 years, Castrol India’s average book value per share growth rate was -1.71% per annum.
During last 10 years, Castrol India’s average book value per share growth rate was -10.06% per annum.
In last 10 years the market price of Castrol India has grown at rate of 16.57% per annum.
In the past 15 years, the best three year average book value per share growth rate of Castrol India was 6.26%between year dec’16 and dec’14. The worst 3 years growth rate was -16.51% between year dec’10 and dec’08.
Castrol India’s current market price is Rs395.40. Its book value per share for the year ending dec’16 is Rs12.05. Hence, its Price to Book Value ratio (P/B) is 32.81.
In last 10 years, the highest P/B value ratio of Castrol India was 47.11 in year 2014. The lowest P/B ratio in last 10 years was 2.11 in year 2008. The median P/B ratio in last 10 years was 14.80
#2. Bosch India
Bosch India’s book value per share for the year ending Mar’2016 was Rs2639.84.
During last 12 months, Bosch India’s average book value per share growth rate was 12.81% per annum.
During last 3 years, Bosch India’s average book value per share growth rate was 9.6% per annum.
During last 5 years, Bosch India’s average book value per share growth rate was 11.88% per annum.
During last 10 years, Bosch India’s average book value per share growth rate was 15.27% per annum.
In last 10 years the market price of Bosch India has grown at rate of 19.24% per annum.
In the past 15 years, the best three year average book value per share growth rate of Bosch India was 24.58%between year dec’06 and dec’04. The worst 3 years growth rate was -41% between year dec’05 and dec’03.
Bosch India’s current market price is Rs24,511. Its book value per share for the year ending Mar’16 is Rs2,639.84. Hence, its Price to Book Value ratio (P/B) is 9.28.
In last 10 years, the highest P/B value ratio of Bosch India was 11.02 in year 2015. The lowest P/B ratio in last 10 years was 3.22 in year 2008. The median P/B ratio in last 10 years was 5.01.